Liquidity risk

Definition

Liquidity risk for a bank is the risk of not being able to meet obligations in terms of funds demanded by clients. This applies to both sides of the balance sheet of banks, i.e. to withdrawals of deposits and to loans drawn down by borrowing clients in terms of loan commitments made by the banks.

Banks are in the financial intermediation business and essentially transmute mostly short-term, i.e. liquid, deposits, into loans and advances and investments, which are for the most part non-liquid and have a longer tenor. No bank can therefore repay all deposits immediately. Banks rely on the law of large numbers, which holds that only a certain proportion of depositors will demand their funds at the same time, and determines its liquid asset holdings (its securities that are quickly reversible into funds) accordingly.

Balance sheet changes resulting from deposit withdrawals and drawdowns on loan facilities

It will be apparent that when deposits are withdrawn, this creates a need for the bank to acquire deposits from other sources, or to undertake the sale of an asset. Similarly, if loan facilities are drawn down in terms of loan commitments provided to clients, this creates an asset, which can only come about if the bank acquires deposits (or loans) or sells assets to the required amount. These scenarios may be depicted as in Balance Sheets 1-4.

Public withdraws deposits (bank funds with other deposits):

Public withdraws deposits (bank funds by selling securities):

Public draws down loan facilities (bank funds with new deposits):

Public draws down loan facilities (bank funds by selling securities):

Conditions for creation of liquidity

Introduction

It will be apparent that the bank, only under certain conditions, can bring about the above balance sheet changes, and these are of crucial importance to the bank and to the banking system in general. The conditions are:

• Firstly, the bank must have an impeccable record, which engenders faith in the bank by the public.

• Secondly, it must have sufficient liquid assets in order to reduce assets to raise funds.

• Thirdly, the secondary financial markets must be such that it is easy to dispose of assets (securities), i.e. the markets must be efficient.

Impeccable record

The first condition is clear. A bank of good standing in the market will easily be able to raise deposits or loans in the market. It is notable that a deposit lost or a loan facility drawn down will result in the relevant bank losing funds, but the funds are not lost to the banking system, i.e. some other bank/s will gain the funds in the form of a deposit. The recipient bank will most likely lend these funds to the deficit bank in the interbank market (see Balance Sheets 5-6). But, this will only take place if the deficit bank is of good standing.

Public withdraws deposits from Bank A (Bank A funds by interbank loan):

Public deposits funds with Bank B (bank makes interbank loan to Bank A):

Volume of and the type of liquid assets

The second condition refers to the volume of and the type of liquid assets. Banks may have a proportion of their liquid assets in the form of interbank loans. In this case the interbank loans are simply drawn down to fund the public deposit lost. The bank that loses the interbank loan will receive the public deposit lost to the first bank (either directly or through the interbank market - we assume the former). This is depicted In Balance Sheets 7-8).

Public withdraws deposits from Bank A (Bank A funds by withdrawing interbank loan with Bank B):

Bank B loses interbank loan (Bank B funds by taking in deposit from public):

However, this is not always the case. Not all banks are willing to lend to all other banks. Also, the private banking system may lose funds to the central bank (because of its operations in the market). In this case the bank is obliged to sell securities (assets). The only securities that a bank is able to sell are liquid asset securities, such as:

• Treasury bills.

• Commercial paper.

• Negotiable certificates of deposit (NCDs).

• Central bank bills.

• Government bonds.

It will be apparent that the bank must have sufficient of these liquid assets to meet the potential demand for funds. These securities may be disposed of in one or more of three ways:

• Sell securities outright in the secondary market.

• Sell securities under repurchase agreement for the period for which funds will most likely be short.

• Acquire accommodation from the central bank (this only applies if the central bank has made the market short of liquidity).

It is important to point out the difference between de facto and de jure liquid assets. The de jure list is the list of securities that may be used by banks:

• To comply with the statutory liquid asset requirement.

• For accommodation from the central bank (overnight loans against collateral or repos). The list of de jure liquid assets in most countries is:

• Treasury bills.

• Central bank bills.

• Government bonds.

The de facto list is the above plus NCDs and commercial paper.

One of the prudential requirements (discussed later) of most countries is a statutory liquid asset requirement (LAR). The LAR differs from country to country and is usually in the range 5% - 10% of liabilities to the public. Although this seems low, it must be kept in mind that a number of other de jure non-liquid securities have sufficiently active secondary markets, in order for them to be sold at short notice. The markets for NCDs and CP are good examples.

Active secondary financial markets

A statutory LAR and voluntary liquid asset holdings will be of no use to a bank in terms of the availability of liquidity, unless there is a market in which they may be sold. It is also important that the markets are of sufficient depth and breadth (efficient) so that a large volume sale will not adversely affect security prices.