Chapter 17: Liquidity Risk Management (CAIIB – Paper 2)
1. What is the primary objective of liquidity risk management in a bank?
A. Maximizing short-term profits only
B. Reducing credit risk
C. Ensuring the bank can meet its financial obligations as they fall due
D. Increasing market share
Liquidity risk management ensures that a bank has sufficient cash or liquid assets to meet its obligations on time, thus avoiding insolvency or financial stress.
2. Which of the following is NOT typically a driver of liquidity risk for banks?
A. Unexpected deposit withdrawals
B. Increased employee training programs
C. Market disruptions affecting asset sales
D. Rapid credit expansion without sufficient funding
Liquidity risk arises from factors affecting the bank's ability to fund its assets or meet liabilities. Employee training programs do not directly impact liquidity.
3. A potential liquidity risk driver from the liability side could be:
A. Slow loan recovery from borrowers
B. Fall in market value of securities held
C. Operational errors in branch operations
D. Large, unexpected withdrawals of deposits
Liability-side liquidity risk arises when a bank faces sudden or large withdrawals of deposits, requiring immediate cash or liquid assets to meet obligations.
4. Which of the following best explains the need for liquidity risk management?
A. To ensure uninterrupted banking operations and maintain market confidence
B. To maximize dividend payout to shareholders
C. To reduce employee workload in treasury operations
D. To comply only with Basel III capital requirements
Effective liquidity risk management ensures that a bank can meet its obligations, maintain smooth operations, and uphold confidence among depositors and counterparties.
5. Which scenario represents a potential liquidity risk from the asset side?
A. Sudden withdrawal of customer deposits
B. Inability to sell loans or securities quickly without significant loss
C. Increase in interest income from performing loans
D. Branch expansion in rural areas
Asset-side liquidity risk occurs when the bank cannot quickly convert assets like loans or securities into cash without incurring losses.
6. Which of the following is an example of funding liquidity risk?
A. Sudden drop in stock market indices
B. Operational errors in payment systems
C. Inability to raise cash quickly to meet obligations
D. Increase in long-term loan defaults
Funding liquidity risk arises when a bank cannot quickly obtain cash to meet its obligations, despite having sufficient assets.
7. Market liquidity risk refers to:
A. Risk of rising interest rates affecting deposits
B. Difficulty in selling assets without significant price reduction
C. Sudden withdrawal of customer deposits
D. Regulatory non-compliance penalties
Market liquidity risk occurs when a bank is unable to sell assets or close positions quickly at current market prices without incurring losses.
8. Which of the following is a key principle for sound liquidity risk management?
A. Maintaining adequate liquidity buffers
B. Maximizing short-term profits
C. Ignoring stress testing assumptions
D. Reducing capital adequacy requirements
Maintaining sufficient liquidity buffers is essential to meet obligations during normal and stressed conditions, forming a key principle of liquidity risk management.
9. Stress testing in liquidity risk management primarily helps in:
A. Predicting customer deposit trends only
B. Calculating net interest income
C. Setting branch expansion targets
D. Assessing the bank's ability to withstand severe liquidity shocks
Liquidity stress testing evaluates whether a bank can survive extreme but plausible liquidity events, helping in planning risk mitigation strategies.
10. Which principle emphasizes that liquidity management should be integrated with overall risk management and business strategy?
A. Maintaining minimum regulatory capital
B. Integrated approach principle
C. Profit maximization principle
D. Asset-liability mismatch principle
The integrated approach principle states that liquidity risk management should be embedded in overall risk management and align with the bank’s strategic goals.
11. Who is primarily responsible for overseeing liquidity risk management in a bank?
A. Branch Manager
B. Operations Team
C. Customer Service Department
D. Board of Directors and Asset-Liability Committee (ALCO)
Governance of liquidity risk involves oversight by the Board of Directors and the Asset-Liability Committee (ALCO) to ensure sound policies and monitoring of liquidity positions.
12. A bank’s liquidity risk management policy should primarily:
A. Focus only on short-term profits
B. Define strategies, roles, responsibilities, and limits to manage liquidity risk
C. Be revised only during financial audits
D. Avoid setting limits to allow flexibility
A comprehensive liquidity risk management policy outlines the bank's approach, including strategies, roles, responsibilities, limits, and contingency plans.
13. Which committee in a bank typically monitors liquidity risk and approves related policies?
A. Audit Committee
B. Human Resources Committee
C. Asset-Liability Committee (ALCO)
D. Credit Approval Committee
The ALCO is responsible for monitoring liquidity positions, setting limits, and ensuring that liquidity risk policies are effectively implemented.
14. Which of the following should be included in a liquidity risk management policy?
A. Contingency funding plans, risk limits, reporting framework, and responsibilities
B. Only funding sources and capital adequacy
C. Marketing strategies for deposit mobilization
D. Employee incentive programs
A robust liquidity risk management policy defines risk limits, reporting structures, contingency funding plans, and clear roles and responsibilities.
15. Contingency funding plans in liquidity risk policy are designed to:
A. Reduce employee workload in treasury
B. Ensure availability of funds during unforeseen liquidity stress events
C. Maximize short-term profits
D. Delay regulatory reporting
Contingency funding plans outline alternative funding sources and actions a bank can take to manage liquidity during unexpected stress situations.
16. Which of the following is a common strategy for managing liquidity risk?
A. Maximizing short-term profits only
B. Ignoring regulatory limits
C. Maintaining adequate liquid assets and contingency funding plans
D. Reducing capital adequacy ratios
A key strategy to manage liquidity risk is holding sufficient liquid assets and preparing contingency funding plans to handle unexpected cash flow needs.
17. ALM (Asset-Liability Management) is important in liquidity risk management because it:
A. Determines employee compensation
B. Aligns cash inflows and outflows to avoid liquidity mismatches
C. Sets marketing goals for deposit mobilization
D. Measures branch performance
ALM ensures that the timing and volume of cash inflows and outflows are managed to minimize liquidity mismatches and funding risks.
18. The Liquidity Coverage Ratio (LCR) is designed to:
A. Measure profitability of loan products
B. Assess market risk exposure
C. Monitor employee performance
D. Ensure banks maintain enough high-quality liquid assets to survive a 30-day stress scenario
The LCR requires banks to hold sufficient high-quality liquid assets to withstand a 30-day period of significant liquidity stress.
19. Net Stable Funding Ratio (NSFR) is aimed at:
A. Increasing short-term lending
B. Reducing employee turnover
C. Promoting longer-term stable funding to support bank assets
D. Measuring market liquidity risk only
NSFR ensures banks have sufficient stable funding over a one-year horizon to support their assets and reduce reliance on short-term funding.
20. A high current ratio in liquidity risk management indicates:
A. Low liquidity and higher risk
B. Adequate liquid assets to cover short-term liabilities
C. Poor asset quality
D. High credit risk exposure
The current ratio measures the ability of a bank to meet its short-term liabilities with short-term assets; a higher ratio indicates better liquidity.
21. What is the main purpose of liquidity stress testing in banks?
A. To evaluate employee efficiency
B. To maximize short-term profits
C. To determine market share
D. To assess the bank's resilience under extreme but plausible liquidity scenarios
Liquidity stress testing helps banks evaluate whether they can withstand severe but plausible liquidity shocks and plan appropriate mitigation strategies.
22. Which of the following is a typical scenario used in liquidity stress testing?
A. Increase in marketing expenses
B. Launch of a new product
C. Sudden large deposit withdrawals or interbank market disruptions
D. Employee resignation trends
Stress testing typically includes scenarios like unexpected withdrawals, market disruptions, or other events that may cause liquidity strain.
23. A Contingency Funding Plan (CFP) is designed to:
A. Reduce employee workload in treasury
B. Ensure availability of alternative funding sources during liquidity stress
C. Increase short-term lending without limits
D. Focus solely on profit maximization
The CFP outlines the strategies and alternative funding sources that a bank can use to meet its liquidity needs during unexpected stress events.
24. Which of the following elements is typically included in a Contingency Funding Plan?
A. Marketing and branch expansion plans
B. Employee training programs
C. Identification of potential liquidity stress events, funding sources, and escalation procedures
D. Dividend payout strategy
A comprehensive CFP includes identification of liquidity stress events, potential alternative funding sources, and procedures to escalate and manage the situation.
25. How often should banks typically review and update their Contingency Funding Plan?
A. Only during annual audits
B. Every five years
C. When a new product is launched
D. Regularly and whenever there are significant changes in liquidity risk profile
Banks should periodically review and update their CFP to ensure it remains effective and aligned with changes in market conditions or the bank’s liquidity risk profile.
26. Which of the following best describes the overseas operations of Indian banks?
A. Operations limited to domestic branches only
B. Operations through branches, subsidiaries, or representative offices in foreign countries
C. Only investing in foreign stocks
D. Conducting business solely through correspondent banks
Indian banks operate overseas through branches, subsidiaries, or representative offices to facilitate international trade, foreign exchange, and global banking services.
27. What is a key regulatory requirement for Indian banks opening a branch abroad?
A. Approval from local branch manager only
B. No approval is needed
C. Approval from the Reserve Bank of India (RBI) and compliance with host country regulations
D. Only shareholder approval
Indian banks must obtain RBI approval and comply with the regulatory framework of the host country before opening overseas branches or subsidiaries.
28. What is the primary function of foreign bank branches in India?
A. Operate only in rural areas
B. Conduct commercial banking operations such as deposits, loans, and foreign exchange
C. Issue government bonds only
D. Only provide consultancy services
Foreign banks in India operate through branches to provide banking services such as deposits, lending, trade finance, and foreign exchange operations.
29. Which of the following is a common risk associated with overseas banking operations?
A. Branch staff shortage in domestic offices
B. Lack of domestic marketing campaigns
C. Increase in domestic deposits
D. Currency risk, regulatory compliance risk, and geopolitical risk
Overseas operations expose banks to additional risks including currency fluctuations, differing regulatory frameworks, and geopolitical uncertainties.
30. Which of the following best explains the difference between an overseas branch and a subsidiary of an Indian bank?
A. Branch is a separate legal entity; subsidiary is not
B. Both are legally the same as the parent bank
C. Branch is part of the parent bank and not a separate legal entity, while a subsidiary is a separate legal entity incorporated in the host country
D. Subsidiary cannot conduct banking operations
An overseas branch is legally part of the parent bank, whereas a subsidiary is incorporated in the host country as a separate legal entity subject to local regulations.
31. Which of the following is a broad norm in liquidity management for banks?
A. Focus only on maximizing short-term profits
B. Ignore regulatory guidelines if profits are high
C. Maintain adequate liquid assets, manage ALM gaps, and comply with regulatory requirements
D. Avoid maintaining contingency funding plans
Broad liquidity norms require banks to hold sufficient liquid assets, manage asset-liability mismatches, and comply with regulatory guidelines to ensure stable operations.
32. Liquidity across currencies is important because:
A. All bank transactions occur only in domestic currency
B. Banks need to meet obligations in multiple currencies due to foreign operations and forex transactions
C. Foreign currency liquidity is irrelevant for domestic banks
D. Liquidity ratios are calculated only in local currency
Banks involved in international operations or foreign exchange transactions must manage liquidity in multiple currencies to meet obligations and avoid foreign exchange mismatches.
33. Which of the following practices helps manage liquidity risk across currencies?
A. Ignoring forex exposure in balance sheet
B. Relying solely on domestic currency deposits
C. Avoiding international operations completely
D. Matching inflows and outflows in each currency and maintaining foreign currency liquid assets
Effective management of liquidity across currencies involves monitoring cash flows in each currency and maintaining adequate foreign currency liquid assets.
34. Regulatory guidelines for liquidity management across currencies require banks to:
A. Convert all foreign currency obligations to domestic currency only
B. Maintain minimum liquidity buffers in foreign currencies based on anticipated obligations
C. Ignore ALM gaps in foreign currency operations
D. Avoid foreign currency lending entirely
Banks must maintain adequate liquidity in foreign currencies to meet obligations and comply with regulatory requirements for cross-currency operations.
35. Which of the following ratios is commonly used to monitor liquidity across currencies?
A. Return on Assets (ROA)
B. Capital Adequacy Ratio (CAR)
C. Liquidity Coverage Ratio (LCR) in each currency
D. Net Interest Margin (NIM)
The LCR is calculated separately for major currencies to ensure banks have sufficient high-quality liquid assets to meet obligations in each currency under stress scenarios.
36. What is the primary purpose of a Management Information System (MIS) in liquidity risk management?
A. To train employees in customer service
B. To maximize short-term profits
C. To track employee attendance
D. To provide timely and accurate information for monitoring and managing liquidity risk
MIS provides critical data and reports to the management for monitoring liquidity positions, assessing risks, and taking informed decisions.
37. Banks are required to report liquidity positions to the Reserve Bank of India (RBI) to:
A. Monitor employee efficiency
B. Ensure regulatory compliance and systemic stability
C. Promote marketing campaigns
D. Set branch expansion targets
Reporting liquidity positions to the RBI ensures that banks comply with regulatory norms and helps maintain the stability of the banking system.
38. Which of the following is a key component of internal controls in liquidity risk management?
A. Employee recruitment policies
B. Marketing strategy for deposits
C. Segregation of duties, approval limits, and regular audits
D. Expansion of branch network only
Internal controls in liquidity management include segregation of duties, defined approval limits, monitoring processes, and regular audits to prevent errors and misuse.
39. Which type of report is typically generated for the RBI to monitor liquidity?
A. Employee attendance report
B. Daily cash position, LCR, and other liquidity ratios
C. Marketing expenditure report
D. Branch expansion plan
Banks report their liquidity positions, including daily cash, LCR, and other key ratios, to the RBI to ensure monitoring and regulatory compliance.
40. Effective internal controls in liquidity risk management help in:
A. Increasing marketing campaigns
B. Maximizing short-term profits only
C. Expanding branch network without risk assessment
D. Preventing operational errors, fraud, and ensuring accurate liquidity reporting
Internal controls help safeguard bank assets, prevent errors or fraud, and ensure accurate reporting for monitoring liquidity risk effectively.
