Liquidity in banking refers to the ability of a bank to meet its financial obligations as they come due. It can come from direct cash holdings in currency or on account at the Federal Reserve or other central bank. More frequently, it comes from acquiring securities that can be sold quickly with minimal loss. This basically states highly creditworthy securities, comprising of government bills, which have short term maturities.
If their maturity is short enough the bank may simply wait for them to return the principle at maturity. For short term, very safe securities favor to trade in liquid markets, stating that large volumes can be sold without moving prices too much and with low transaction costs.
Nevertheless, a bank’s liquidity condition, particularly in a crisis, will be affected by much more than just this reserve of cash and highly liquid securities. The maturity of its less liquid assets will also matter. As some of them may mature before the cash crunch passes, thereby providing an additional source of funds.
We are concerned about bank liquidity levels as banks are important to the financial system. They are inherently sensitive if they do not have enough safety margins. We have witnessed in the past the extreme form of damage that an economy can undergo when credit dries up in a crisis. Capital is arguably the most essential safety buffer. This is because it supports the resources to reclaim from substantial losses of any nature.
The closest cause of a bank’s demise is mostly a liquidity issue that makes it impossible to survive a classic “bank run” or, nowadays, a modern equivalent, like an inability to approach the debt markets for new funding. It is completely possible for the economic value of a bank’s assets to be more than enough to wrap up all of its demands and yet for that bank to go bust as its assets are illiquid and its liabilities have short-term maturities.
Banks have always been reclining to runs as one of their principle social intentions are to perform maturity transformation, also known as time intermediation. In simple words, they yield demand deposits and other short term funds and lend them back out at longer maturities.
Maturity conversion is useful as households and enterprises often have a strong choice for a substantial degree of liquidity, yet much of the useful activity in the economy needs confirmed funding for multiple years. Banks square this cycle by depending on the fact that households and enterprises seldom take advantage of the liquidity they have acquired.
Deposits are considered sticky. Theoretically, it is possible to withdraw all demand deposits in a single day, yet their average balances show remarkable stability in normal times. Thus, banks can accommodate the funds for longer durations with a fair degree of assurance that the deposits will be readily available or that equivalent deposits can be acquired from others as per requirement, with a raise in deposit rates.
Large banking groups engage themselves in substantial capital markets businesses and they have considerable added complexity in their liquidity requirements. This is done to support repo businesses, derivatives transactions, prime brokerage, and other activities.
Banks can achieve liquidity in multiple ways. Each of these methods ordinarily has a cost, comprising of −
This can assist in two fundamental ways. The first way states that, if the maturity of some assets is shortened to an extent that they mature during the duration of a cash crunch, then there is a direct benefit. The second way states that, shorter maturity assets are basically more liquid.
Assets that will mature over the time horizon of an actual or possible cash crunch can still be crucial providers of liquidity, if they can be sold in a timely manner without any redundant loss. Banks can raise asset liquidity in many ways.
Typically, securities are more liquid than loans and other assets, even though some large loans are now framed to be comparatively easy to sell on the wholesale markets. Thus, it is an element of degree and not an absolute statement. Mostly shorter maturity assets are more liquid than longer ones. Securities issued in large volume and by large enterprises have greater liquidity, because they do more creditworthy securities.
The longer duration of a liability, the less it is expected that it will mature while a bank is still in a cash crunch.
Common stocks are barely equivalent to an agreement with a perpetual maturity, with the combined benefit that no interest or similar periodic payments have to be made.
Cutting back the amount of lines of credit and other contingent commitments to pay out cash in the future. It limits the potential outflow thus reconstructing the balance of sources and uses of cash.
A bank can scale another bank or an insurer, or in some cases a central bank, to guarantee the connection of cash in the future, if required. For example, a bank may pay for a line of credit from another bank. In some countries, banks have assets prepositioned with their central bank that can further be passed down as collateral to hire cash in a crisis.
All the above mentioned techniques used to achieve liquidity have a net cost in normal times. Basically, financial markets have an upward sloping yield curve, stating that interest rates are higher for long-term securities than they are for short-term ones.
This is so mostly the case that such a curve is referred as normal yield curve and the exceptional periods are known as inverse yield curves. When the yield curve has a top oriented slope, contracting asset maturities decreases investment income while extending liability maturities raises interest expense. In the same way, more liquid instruments have lower yields, else equal, minimizing investment income.