2. Assumptions

Hypotises are:

1. There is a significant reverse relationship between liquidity level and bank profitability. The excess of liquid assets leads to decrease of bank profitability.

2. Bank’s liquidity ratios are close to the normative coefficients established by Central bank of Russia in periods of stable economic situation in a country. Bank’s liquidity ratios are higher than the normative coefficients during a period of liquidity crisis.

2. Basic definitions

   1. Liquidity risk

The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole.

Liquidity risk - current and potential risk to earnings and the market value of stockholder’s equity that results from bank’s inability to meet payment or clearing obligations in a timely and cost-effective manner.

Depending on the possible impact area, however, the liquidity risk suffered by a bank falls into one of two intrinsically linked macro-categories: funding liquidity risk and market liquidity risk.

Funding liquidity risk refers to the possibility that the bank may not be able to settle its obligations immediately and in a cost-effective way. It depends on expected and unexpected future cash inflows and outflows, linked to repayments of its liabilities, commitments to provide funds or requests to increase already provided guarantees.

Market liquidity risk, by contrast, is the risk which a bank may face when unable to convert a position on a given financial asset into money or when it has to liquidate it and take a price cut, due to the insufficient market liquidity in which such an asset is negotiated, or to a temporary malfunctioning of the market itself.

Generally speaking, a firm can provide for its liquidity needs in one of two ways:

1. By holding liquid assets;

2. By securing its ability to borrow (issuing new liabilities) at reasonable cost.

Thus, when depository institutions need cash, they can either sell liquid assets or increase borrowings. Liquidity risk metrics focus on the quantity and quality of liquid assets near maturity or available-for-sale at reasonable prices, as well as the firm’s ability to cheaply and easily borrow funds to meet cash outflows [2, p. 431].

2. Liquidity risk management

Risk management is the process by which managers identify, assess, monitor, and control risks associated with a financial institution’s activities. Virtually every financial transaction or commitment has implications for a bank’s liquidity. Effective liquidity risk management helps ensure a bank's ability to meet cash flow obligations, which are uncertain as they are affected by external events and other agents' behaviour. Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial market developments in the past decade have increased the complexity of liquidity risk and its management [4, p. 8].

 The primary role of liquidity-risk management is to prospectively assess the need for funds to meet obligations and ensure the availability of cash or collateral to fulfill those needs at the appropriate time by coordinating the various sources of funds available to the institution under normal and stressed conditions.

The aims of liquidity risk management are:

• to ensure at all times an adequate corresponding balance between cash inflows and cash outflows, thus guaranteeing the solvency of the bank;

• to coordinate the issuing by the bank of short, medium and long term financing instruments;

• to optimise the costs of refinancing, striking a trade-off balance between liquidity and profitability;

• to optimise, for banks structured as banking groups, the intra-group management of cash flows, with the aim of reducing dependence on external financial requirements, by means of cash pooling techniques or other optimization instruments.

The liquidity management processes and related risks vary depending on the size of the bank, the type of its main activity, the degree of internationalization and its organisational complexity [6, p. 124].