LEARNING SECTION 01
What is liquidity risk in a bank?
Liquidity risk is the risk that a bank cannot meet payment obligations when due without incurring unacceptable losses. The obligation can arise from a deposit withdrawal, a maturing loan, a payment settlement, a credit-line drawdown or a collateral call.
Banks transform maturities: depositors may want cash quickly while borrowers repay over years. This supports credit creation, but creates a need for reliable cash forecasting, liquid assets and funding contingency plans.
| Concept | Question | Example |
|---|---|---|
| Funding liquidity | Can the bank obtain usable cash in the required amount, currency and time? | A wholesale lender refuses to renew a deposit. |
| Market liquidity | Can the bank sell or hedge an asset without an excessive discount or price impact? | A corporate-bond position attracts only deeply discounted bids. |
| Solvency | Do assets and loss-absorbing capital support the bank’s obligations? | Loan losses erode equity even though cash payments continue today. |
A solvent bank can face a cash shortfall. A bank with cash today can still have an unsustainable capital position. Capital and liquidity assessments must therefore work together.
LEARNING SECTION 02
How a liquidity spiral develops
Imagine a bank holding long-term securities funded by concentrated deposits. A rate rise reduces securities values. Concern about the bank causes withdrawals. The bank sells securities, realises losses and weakens confidence further.
| Stage | Immediate effect | Possible next effect |
|---|---|---|
| Funding withdrawals | Cash leaves the bank | The bank sells assets or seeks secured borrowing. |
| Asset sale at a discount | Sale proceeds are below carrying or reference value | Losses weaken capital and market confidence. |
| Collateral haircut rises | Each pledged asset raises less cash | More collateral or cash becomes necessary. |
| Confidence deteriorates | More depositors and lenders withdraw | The bank’s funding options become narrower. |
A hedge can protect economic value while generating a margin call before its offsetting cash benefit arrives. Liquidity planning must track settlement timing as well as gains and losses.
Three crises, three funding lessons
Silicon Valley Bank, 2023: concentrated uninsured deposits and interest-rate risk made the bank vulnerable to rapid withdrawals. Securities losses, confidence and funding pressure interacted. Federal Reserve review.
Northern Rock, 2007: reliance on wholesale funding became a critical vulnerability when markets froze; emergency liquidity support was followed by a retail run. UK Treasury Committee report.
Yes Bank, India, 2020: deteriorating liquidity and capital, alongside the absence of a credible capital-infusion plan, led to a moratorium and reconstruction. This illustrates how funding confidence and solvency concerns can reinforce each other. RBI reconstruction announcement.
These events had different causes and resolution mechanisms. They illustrate related vulnerabilities rather than an identical sequence of events.
LEARNING SECTION 03
What should a liquidity dashboard measure?
| Measure | What it reveals | Management use |
|---|---|---|
| Bid–ask spread | Immediate trading cost relative to a reference price | Trading limits and exit planning |
| Market depth and price impact | Whether quoted prices survive a large trade | Position sizing and liquidation schedules |
| Contractual and behavioural cash gaps | When expected inflows and outflows differ | Funding plans by maturity bucket |
| Survival horizon | First cash shortfall under stated stress assumptions | Liquidity-buffer and contingency targets |
| Funding concentration | Dependence on a few depositors, markets or maturities | Diversification and concentration limits |
| Asset encumbrance | Assets already pledged or otherwise unavailable | Collateral capacity and mobilisation |
| Liquidity Coverage Ratio and Net Stable Funding Ratio | Short-term stressed buffer and structural funding resilience | Regulatory monitoring alongside internal metrics |
The dashboard should distinguish currencies, legal entities and operating time zones. Surplus cash in one subsidiary may be unavailable to another because of legal, regulatory or operational restrictions.
LEARNING SECTION 04
Bid–ask spreads: the cost of an immediate exit
The bid is the price at which a dealer buys from you. The ask is the price at which a dealer sells to you. The midpoint is their average. For a long position marked at the midpoint, an immediate sale at the bid sacrifices half the quoted spread, assuming sufficient depth.
With bid ₹99.50 and ask ₹100.50, the midpoint is ₹100 and the proportional spread is 1%. Selling a ₹50 crore long holding costs approximately ½ × 1% × 50 = ₹0.25 crore, or ₹25 lakh, relative to its midpoint value.
A short position is closed by buying at the ask. A buy-and-sell round trip incurs the full spread under unchanged quotes. Fees, market impact and changing prices add further costs.
LEARNING SECTION 05
A portfolio liquidity-cost illustration
| Hypothetical asset | Midpoint value (₹ crore) | Full proportional spread | One-way cost (₹ crore) |
|---|---|---|---|
| Large-cap shares | 40 | 0.2% | 0.040 |
| Government securities | 30 | 0.1% | 0.015 |
| Corporate bonds | 20 | 1.0% | 0.100 |
| Mid-cap shares | 10 | 2.0% | 0.100 |
| Total | 100 | 0.51% (value-weighted) | 0.255 |
The ₹30 crore corporate-bond and mid-cap positions create ₹0.20 crore of the ₹0.255 crore exit cost, about 78.43%. A smaller, less liquid allocation can dominate trading costs.
The formula assumes each position can trade at the displayed bid or ask. A large order can walk through the order book, so the realised cost may exceed half the spread.
One-way exit cost = ½ × 0.51% × ₹100 crore = ₹0.255 crore.
LEARNING SECTION 06
Liquidity-adjusted Value at Risk
Value at Risk (VaR) is a loss quantile at a stated confidence level and horizon. A simple Liquidity-adjusted Value at Risk (LVaR) adds an estimated liquidation cost to a market-risk measure.
If market Value at Risk is ₹3.49 crore and the preceding exit cost is ₹0.255 crore, the additive result is ₹3.745 crore.
For a directly comparable stress on the same ₹100 crore portfolio, use its 0.51% value-weighted mean full spread, an assumed spread standard deviation of 0.5 percentage point and multiplier 2.33. The stressed full spread is 0.51% + 2.33 × 0.5% = 1.675%. Half-spread cost is ½ × 1.675% × 100 = ₹0.8375 crore; adding market VaR of ₹3.49 crore gives ₹4.3275 crore, compared with ₹3.745 crore at constant spreads. The spread-volatility and multiplier inputs are illustrative modelling assumptions, not regulatory parameters.
These are approximations, not a universal regulatory formula. Adding two tail estimates does not generally produce the exact quantile of their sum. Price losses, spread widening and funding stress can depend on one another, and a normal spread approximation can produce implausible values.
LEARNING SECTION 07
Market depth, liquidation time and collateral haircuts
A position worth ₹60 crore in a market with ₹20 crore average daily turnover cannot necessarily be sold at quoted prices in one transaction. At an assumed participation limit of 10% of daily turnover, planned sales are ₹2 crore a day, implying 30 trading days before price changes, volume shifts and execution constraints.
Slower sales may reduce market impact but leave exposure open longer. A liquidity-horizon assumption is therefore a modelling choice, rather than a guarantee that every position can be exited within that period.
Collateral valued at ₹100 crore raises ₹95 crore under a 5% haircut. At a 15% haircut, it raises ₹85 crore, a ₹10 crore reduction even before a market-price decline.
Encumbered assets already secure an obligation and may be unavailable for another use. Do not count one security simultaneously as sale proceeds and as collateral supporting a new borrowing.
LEARNING SECTION 08
Cash-flow maturity ladder: where does the gap occur?
| Bucket | Inflows | Outflows | Net flow | Cumulative net flow | Cash after ₹200 crore opening buffer |
|---|---|---|---|---|---|
| Day 1 | 300 | 450 | −150 | −150 | 50 |
| Days 2–7 | 500 | 600 | −100 | −250 | −50 |
| Days 8–14 | 400 | 350 | +50 | −200 | 0 |
| Days 15–30 | 700 | 500 | +200 | 0 | 200 |
All amounts are ₹ crore. The bank returns to an aggregate balanced flow by day 30, but faces a ₹50 crore funding gap in the days 2–7 bucket. Future inflows cannot pay earlier obligations without bridging funding.
The ladder locates a shortfall somewhere in that bucket. Exact survival time requires daily or intraday timing. At day 7, the ₹250 crore cumulative net deficit is 250/(450+600) = 23.81% of cumulative outflows. For a covered commercial bank, this exceeds the RBI day-7 cumulative mismatch limit of 10%; the opening cash buffer is shown separately in this simplified ladder.
Contractual maturities need behavioural adjustments for early withdrawals, loan prepayments, committed-line drawdowns and realistic renewal rates. Those adjustments should be transparent and independently challenged.
RBI commercial-bank cumulative mismatch limits
| Bucket end | Maximum net cumulative negative mismatch / cumulative outflows |
|---|---|
| Next day | 5% |
| Days 2–7 | 10% |
| Days 8–14 | 15% |
| Days 15–30 | 20% |
The case gives day-1 mismatch of 150/450 = 33.33%, day-7 mismatch of 250/1,050 = 23.81%, day-14 mismatch of 200/1,400 = 14.29% and day-30 mismatch of 0.00%. The first two exceed these limits. This is an illustrative comparison of the displayed cash flows, not a completed regulatory SLS: actual reporting must follow RBI slotting rules, including treatment of cash and other assets. RBI Commercial Banks ALM Directions, paragraph 43. NBFCs use a different schedule.
LEARNING SECTION 09
Survival horizon and reverse liquidity stress
Survival horizon is the first time usable resources fail to meet cumulative stressed cash needs, given an explicit definition of available funding. A constant-burn shortcut is:
A ₹120 crore buffer with a steady ₹15 crore daily net burn lasts eight days. This assumes the buffer is immediately usable and daily burn stays constant.
A reverse run-off calculation
Assume ₹150 crore usable resources, ₹50 crore credible inflows, ₹80 crore other payments and ₹1,000 crore deposits. The aggregate withdrawal fraction that exhausts cash is:
At 12% withdrawal, simplified ending cash reaches zero. Above 12%, there is a shortfall. Earlier payment timing can cause failure before that aggregate threshold is reached.
Test an institution-specific shock, a market-wide shock and a combination. Include deposit concentration, loss of unsecured funding, collateral calls, reduced collections and asset-sale discounts.
LEARNING SECTION 10
Liquidity Coverage Ratio: a 30-day buffer
The Liquidity Coverage Ratio (LCR) compares eligible, unencumbered High-Quality Liquid Assets (HQLA), after required haircuts and composition caps, with net cash outflows in a prescribed 30-calendar-day stress.
The Basel normal-times minimum is 100%. The inflow cap ensures that a bank holds liquid assets rather than relying entirely on expected inflows. With outflows of ₹400 crore and inflows of ₹350 crore, recognised inflows are capped at ₹300 crore and net outflows remain ₹100 crore.
During actual stress, banks may draw on the buffer and fall below 100%, subject to the applicable supervisory response. A reported ratio above 100% does not prove that cash is available in every currency or at every point during the day.
LEARNING SECTION 11
High-Quality Liquid Assets: eligibility, haircuts and caps
| Basel category | General treatment | Important qualification |
|---|---|---|
| Level 1 | Generally no Basel composition cap and a 0% Basel haircut for qualifying assets | Eligibility and operational availability matter. National rules may impose valuation adjustments. |
| Level 2A | Generally a 15% haircut | Total Level 2 assets cannot normally exceed 40% of the buffer after required adjustments. |
| Level 2B | Depending on eligible asset type, haircuts can be 25% or 50% | Level 2B is subject to a 15% cap and also sits inside the total Level 2 cap. |
A high credit rating alone does not establish eligibility. Assess market liquidity, currency, issuer restrictions, encumbrance and whether treasury can monetise the asset operationally. Cap calculations can require adjustments for secured transactions maturing within the stress period.
India: SLR carve-outs and valuation haircuts
Eligible government securities above minimum SLR can enter Level 1. Within mandatory SLR, RBI permits the MSF carve-out (2% of NDTL) and FALLCR carve-out (16% of NDTL), subject to eligibility and operational conditions. FALLCR means Facility to Avail Liquidity for Liquidity Coverage Ratio; it is not an unrestricted cash balance.
From 1 April 2026, Level 1 government securities are valued at no more than current market value after applicable LAF/MSF haircuts. Do not treat every SLR security as freely available or count the same security twice. RBI ALM Directions, Level 1 assets; April 2025 amendment.
The worked example below has only Level 1 and Level 2A assets, with the Level 2A share comfortably below the cap. It assumes the Level 1 input is already eligible and adjusted.
LEARNING SECTION 12
Worked LCR: Bank Tunga
All amounts are hypothetical ₹ crore. Assume adjusted eligible Level 1 assets of 900 and Level 2A market value of 300 with a 15% haircut. The run-off rates below are explicit case inputs, rather than a complete deposit-classification rule.
| Component | Calculation | Amount |
|---|---|---|
| Level 1 liquid assets | Already adjusted and eligible | 900 |
| Level 2A liquid assets | 300 × 85% | 255 |
| Adjusted buffer | 900 + 255 | 1,155 |
| Stable digital-enabled retail deposits | 6,000 × 7.5% | 450 |
| Less-stable digital-enabled retail deposits | 2,000 × 12.5% | 250 |
| Non-operational non-financial corporate deposits | 1,000 × 40% | 400 |
| Short-term financial-institution funding | 300 × 100% | 300 |
| Gross outflows | 450 + 250 + 400 + 300 | 1,400 |
| Eligible inflows | min(400, 75% × 1,400) | 400 |
| Net outflows | 1,400 − 400 | 1,000 |
The Level 2A share is 255/1,155 = 22.08%, below the 40% total Level 2 cap in this simple portfolio.
If gross outflows rise to ₹1,600 crore and eligible inflows fall to ₹300 crore, net outflows become ₹1,300 crore. With the buffer unchanged, the ratio falls to 88.85%, creating a ₹145 crore buffer shortfall relative to 100%.
These retail factors follow the RBI circular of 21 April 2025, effective 1 April 2026: an additional 2.5 percentage points applies to qualifying retail deposits enabled for internet/mobile banking, including UPI. Thus stable deposits use 7.5% and less-stable deposits 12.5%, against the 5% and 10% baseline factors. Classification still depends on deposit insurance, relationships and other prescribed criteria; digital access alone does not establish stability.
LEARNING SECTION 13
Net Stable Funding Ratio: the funding structure
The Net Stable Funding Ratio (NSFR) tests structural resilience over a one-year horizon. It compares weighted Available Stable Funding (ASF) with weighted Required Stable Funding (RSF).
Available funding weights reflect its likely stability. Required funding weights reflect assets’ liquidity, maturity, encumbrance and other characteristics. A short contractual maturity does not automatically mean funding receives no stable-funding recognition.
| Illustrative Basel item | Side | Factor or qualification |
|---|---|---|
| Eligible capital and funding with residual maturity at least one year | ASF | Generally 100% |
| Qualifying stable / less-stable retail funding under one year | ASF | Generally 95% / 90% |
| Certain short-term non-financial corporate funding | ASF | 50%, subject to classification |
| Cash / qualifying unencumbered Level 1 securities | RSF | 0% / generally 5% |
| Certain performing non-financial loans under one year | RSF | 50%, subject to conditions |
| Certain performing loans at least one year, with risk weights above 35% | RSF | 85%, subject to conditions |
These examples do not replace the full rulebook. Derivatives, secured funding, off-balance-sheet commitments, financial-sector transactions and encumbered assets have additional treatments.
LEARNING SECTION 14
Worked NSFR: a balanced funding example
Consider this separate hypothetical ₹10,500 crore balance sheet. It illustrates weighted funding rather than every regulatory adjustment. All figures are ₹ crore.
| Funding source | Balance | ASF factor | Weighted ASF |
|---|---|---|---|
| Capital and long-term debt | 1,200 | 100% | 1,200 |
| Qualifying stable retail deposits | 6,000 | 95% | 5,700 |
| Qualifying less-stable retail deposits | 2,000 | 90% | 1,800 |
| Qualifying non-financial corporate funding | 1,000 | 50% | 500 |
| Financial-institution funding under six months | 300 | 0% | 0 |
| Total | 10,500 | 9,200 |
| Asset category | Balance | RSF factor | Weighted RSF |
|---|---|---|---|
| Performing long-term loans meeting the assumed 85% category | 7,000 | 85% | 5,950 |
| Qualifying short-term non-financial loans | 2,000 | 50% | 1,000 |
| Qualifying unencumbered Level 1 securities | 900 | 5% | 45 |
| Qualifying unencumbered Level 2A securities | 300 | 15% | 45 |
| Other assets assigned 100% for this case | 300 | 100% | 300 |
| Total | 10,500 | 7,340 |
If ₹2,000 crore of stable retail funding is replaced by funding that qualifies for 0% Available Stable Funding, weighted funding falls by ₹1,900 crore to ₹7,300 crore. With Required Stable Funding unchanged, the ratio becomes 99.46%. The nominal balance sheet still balances, but its funding quality has deteriorated.
LEARNING SECTION 15
LCR versus NSFR: why a bank needs both
| Feature | Liquidity Coverage Ratio (LCR) | Net Stable Funding Ratio (NSFR) |
|---|---|---|
| Main purpose | Absorb a prescribed short-term cash stress | Support a more stable funding structure |
| Horizon | 30 calendar days | One year |
| Numerator | Adjusted High-Quality Liquid Assets | Available Stable Funding |
| Denominator | Stressed net cash outflows | Required Stable Funding |
| Basel standard | At least 100% in normal times | At least 100% on an ongoing basis |
| Limitation | Does not guarantee survival beyond its assumptions or every intraday payment | Does not guarantee payment capacity today |
A bank may meet the 30-day buffer requirement while depending heavily on renewals just beyond day 30. Another may have stable long-term funding but face a temporary settlement or collateral shortfall. Neither ratio replaces a cash-flow ladder, concentration limits and stress testing.
LCR and NSFR assess liquidity and funding; the leverage ratio limits total regulatory exposure relative to Tier 1 capital. A bank must manage both. Read Basel III Leverage Ratio →
LEARNING SECTION 16
Management: funding, buffers and contingency actions
The board sets liquidity risk tolerance. The Asset–Liability Committee (ALCO) translates it into funding strategy, limits and escalation. Treasury executes funding and collateral actions. Risk teams provide independent monitoring and challenge.
| Management tool | Action | Trade-off or constraint |
|---|---|---|
| Diversified funding | Broaden depositor, market, maturity and currency sources | Nominal diversification can conceal common behavioural exposure. |
| Liquid-asset buffer | Hold usable assets and test monetisation | Liquidity protection has a cost and requires operational access. |
| Collateral preparation | Identify eligible assets and pre-position them where appropriate | Eligibility, settlement time and haircuts limit borrowing capacity. |
| Term funding | Reduce reliance on daily renewal | Longer funding may cost more or be unavailable in stress. |
| Contingency Funding Plan (CFP) | Assign triggers, actions, owners, sequence and communication | A plan needs executable transactions and tested systems. |
| Internal funding charges | Allocate liquidity costs to products and business lines | Bad assumptions can encourage unstable funding or misleading profitability. |
A contingency plan should show cash available today, actions possible within one day, and actions needing longer lead times. Distinguish committed from uncommitted facilities. State whether normal central bank access is included. Emergency assistance is not an unconditional funding promise.
Internal liquidity-transfer pricing can charge a long-dated illiquid loan for the stable funding and buffer it consumes. This makes business profitability reflect funding needs.
LEARNING SECTION 17
Early warnings, intraday liquidity and model controls
| Warning or control | What to monitor |
|---|---|
| Deposit behaviour | Large-account withdrawals, uninsured concentration and renewal patterns |
| Market funding | Wider spreads, shorter offered tenors and declining lender limits |
| Collateral | Rising haircuts, more encumbrance and settlement failures |
| Customer drawdowns | Use of undrawn commitments and contingent obligations |
| Intraday payments | Peak cash needs, payment timing and available intraday credit |
| Model validation | Backtest behavioural assumptions and compare projected flows with realised flows |
Model risk arises when deposit stability, rollover, collateral access or asset-sale assumptions are wrong or misused. Test combined adverse changes rather than relying only on an average historical withdrawal rate.
Asset–Liability Management (ALM) also manages interest-rate risk. A repricing gap concerns when assets and liabilities reset their rates. A cash-flow gap concerns when cash is paid. A floating-rate loan may reprice tomorrow but repay principal years later, so those gaps are different.
ALCO reporting should show capital and liquidity effects together. Interest-rate hedges can reduce valuation risk but create collateral cash needs.
LEARNING SECTION 18
Interactive laboratories: liquidity costs and ratios
Use the two laboratories to reproduce the examples. Amounts are ₹ crore unless the field says price. Enter percentage numbers, so 15 means 15%. These are simplified teaching calculators.
Lab 1: portfolio-equivalent bid–ask exit cost
Defaults represent the ₹100 crore portfolio as an equivalent holding priced around ₹100 with a 0.51% full spread: bid ₹99.745 and ask ₹100.255. This reproduces ₹0.255 crore exit cost and ₹3.745 crore additive LVaR. For section 4, enter bid 99.50, ask 100.50 and value 50; its exit cost is ₹0.25 crore. Enter a VaR appropriate to that holding separately.
Lab 2: simplified liquidity ratios
Only Level 1 and Level 2A assets enter this calculator. It applies the simple 40% Level 2 composition limit without secured-transaction unwind adjustments. Inputs must already meet asset eligibility rules. The separate stable-funding inputs are weighted amounts.
LEARNING SECTION 19
Excel formulas and practice questions
Use the following cell map so every result updates when an input changes. Monetary values are ₹ crore. Enter the haircut as an Excel percentage.
| Cell | Input | Base value |
|---|---|---|
| B2 / B3 | Bid / ask | 99.745 / 100.255 |
| B4 / B5 | Position value / market VaR | 100 / 3.49 |
| B8 / B9 / B10 | Adjusted Level 1 / Level 2A market value / haircut | 900 / 300 / 15% |
| B11 / B12 | Gross outflows / eligible inflows | 1,400 / 400 |
| B13 / B14 | Weighted ASF / weighted RSF | 9,200 / 7,340 |
| Result cell and task | Excel formula |
|---|---|
| Midpoint, B6 | =AVERAGE(B2:B3) |
| Full proportional spread, B7 | =(B3-B2)/B6 |
| One-way exit cost, B16 | =0.5*B7*B4 |
| Additive LVaR, B17 | =B5+B16 |
| Recognised Level 2A, B18 | =MIN(B9*(1-B10),B8*40%/(1-40%)) |
| Adjusted HQLA, B19 | =B8+B18 |
| Recognised inflows, B20 | =MIN(B12,75%*B11) |
| Net stressed outflows, B21 | =B11-B20 |
| LCR, B22 | =IF(B21>0,B19/B21,NA()) |
| NSFR, B23 | =IF(B14>0,B13/B14,NA()) |
| Extra buffer to reach 100% LCR, B24 | =MAX(0,B21-B19) |
For LCR stress, set B11 to 1,600 and B12 to 300: LCR becomes 88.85% and B24 becomes ₹145 crore. For NSFR stress, set B13 to 7,300: NSFR becomes 99.46%.
Format ratios as percentages with two decimals. The simplified 40% Level 2 cap is built into B18; secured-transaction unwind adjustments are outside this illustration.
Why does the example cost half the spread rather than the full spread?
The position starts marked at the midpoint and exits once at the bid. A round trip uses both sides under unchanged quotes.
Does a zero day-30 cumulative gap prove the bank survives?
No. Day 30 ends with balanced net flows, but the days 2–7 bucket shows cash of −₹50 crore after the opening buffer. Later inflows cannot pay earlier obligations without bridging funding.
Can 100% of expected inflows offset LCR outflows?
No. Recognised inflows are capped at 75% of gross outflows. With ₹400 crore outflows and ₹350 crore inflows, recognise only ₹300 crore; net outflows remain ₹100 crore.
How can the funding ratio deteriorate without balance-sheet growth?
Replacing ₹2,000 crore of stable retail funding (95% ASF) with funding assigned 0% removes ₹1,900 crore ASF. ASF falls from ₹9,200 crore to ₹7,300 crore, and NSFR falls from 125.34% to 99.46%, with RSF unchanged.
LEARNING SECTION 20
Sources and related reading
- Basel Committee: liquidity risk management and supervision
- Basel Framework: Liquidity Coverage Ratio
- Basel Framework: Net Stable Funding Ratio
- Reserve Bank of India: Commercial Banks, Asset Liability Management Directions
- US interagency funding and liquidity-risk guidance
- RBI, 21 April 2025: digital-deposit run-off factors and Level 1 government-security haircuts, effective 1 April 2026
All numerical case amounts and stress shocks are hypothetical. Regulatory factors are identified and sourced separately.
Basel standards and national implementation can differ. Consult the current Reserve Bank of India directions for the bank’s regulatory classification, asset haircuts, deposit categories, concentration limits and reporting requirements.