Banks Liquidity: How can they solve the problem of liquidity?
As it is widely known, Banks always had a principal role in financial systems. The fundamental role of them, typically, is the transformation of liquid deposit liabilities into illiquid assets such as loans; this makes banks inherently vulnerable to liquidity risk. Because of the potential risks in global financial environment it has to be assured that a financial institution, such as a bank, is able to continue to perform its fundamental role. Although some outflows are known with certainty (certain obligations) there are always lots of possibilities that risk could arise from uncertain cash flow obligations such as to satisfy deposit withdrawals and increased loan demand. For that reason, bank supervisors, in a regular basis, review the liquidity positions and liquidity-risk-management practices of banks and provide them with specific guidelines. According to these specific regulations banks are obligated to hold an adequate amount of liquid assets, such as cash, to manage any potential bank runs by customers.
This essay has been organized around the following issues:
? What is liquidity at a bank and the importance of it?
? How can banks achieve sufficient liquidity?
? What are the new liquidity requirements?
? What is Liquidity Coverage Ratio and how does it work?
? What is Net Stable Funding Ratio and how does it work?
? What are the policy issues around LCR and NSFR?
? What is the role of central banks in providing liquidity?
What is liquidity at a bank and the importance of it?
Liquidity represents the capacity of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses (Basel Committee 2008a). In other words, we could define that liquidity is assuring access to cash when it is needed.
Why it is so important? Bank’s liquidity situation is about the confidence of counterparties and depositors in the institution and its perceived solvency or capital adequacy.
How can banks achieve sufficient liquidity?
There are multiple ways banks can increase their liquidity.
• Shorten asset maturities in order for them to become more liquid.
• Improve the structure of assets by shortened their average liquidity.
Assets that can be sold in a timely manner without excessive loss. For example, securities are normally more liquid than loans and other assets. In general, shorter maturity assets are usually more liquid than longer ones as do more creditworthy securities.
• Lend money from the interbank market
If a bank is facing a liquidity shortage it has to borrow money, usually from the interbank market, so that the shortfall will be covered. In the same time, there are banks which have excess liquid assets above and beyond the liquidity requirements. These banks lend money in the interbank market, receiving interest on the assets.