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1 Introduction
The strength of the banking system is an essential requirement to ensure the economic stability and growth ([17] Halling and Hayden, 2006). Banks are the main part of the financial sector in any economy, performing valuable activities on both sides of the balance sheet. On the asset side, they enhance the flow of funds by lending to the cash starved users of funds, whereas they provide liquidity to savers on the liability side ([10] Diamond and Rajan, 2001).
Banks also facilitate the payments and settlement systems and support the smooth transfer of goods and services. They ensure productive investment of capital to stimulate the economic growth. They help to develop new industries, thereby increasing the employment and facilitating the growth. The varied nature of functions performed by the banks exposes them to liquidity risk - the risk that a bank may not meet its obligations ([21] Jenkinson, 2008) as the depositors may call their funds at an inconvenient time, causing fire sale of assets ([10] Diamond and Rajan, 2001), negatively affecting profitability of the bank ([6] Chaplin et al. , 2000).
Over the past few years, bank managers did not pay the required attention to this vital element of liquidity risk (Committee of European Banking Supervisors ([4] CEBS, 2008)). Lately, it has obtained a significant attention from the researchers, regulators and financial institutions after various economic and banking crises across the globe. There has been an imminent feeling that liquidity risk has not been sufficiently covered with the prevailing risk management practices ([9] Crowe, 2009). It is said to be the assassin of banks ([2] Ali, 2004). This claim finds support from the failure of many banks in the recent past. The banks and regulators are now having deep insight into the liquidity position of banks.
Liquidity risk not only affects the performance of a bank but also its reputation ([21] Jenkinson, 2008). A bank may lose the confidence of its depositors if funds are not timely provided to them. The bank's reputation may become at stake in this situation. In addition to this, a poor liquidity position may cause penalties from the regulator. Therefore, it becomes imperative for a bank to keep a sound liquidity arrangement.
Liquidity risk has become a...