Measures of a bank's liquidity exposure
As discussed, a bank's liquidity risk is a function of the potential withdrawal of deposits and the potential utilization of loan demands under commitments granted, and the need to meet these demands from the sale of securities or the taking in of new deposits / loans. Thus, a bank must at all times be in a position to measure its liquidity situation. There are a number of tools that banks utilize in this regard:
• Net liquidity statement.
• Peer group comparisons.
• Liquidity index.
• Financing gap and the financing requirement.
• Liquidity planning.
The details of these measures will not be discussed here.
Banks are required by regulators submit a return/s on a monthly basis. A central bank31 expounds on the purpose:
"(2) The purpose of the return is to determine: (a) The contractual mismatch between assets and liabilities at the reporting date. (b) The anticipated cash flow requirement from money market sources, as calculated in terms of the ALCO model, for the six months following the reporting month. (c) The extent and anticipated maturity of selected items included in the mismatches reported in terms of...2(a) and2(b) above"
Bank liquidity and a "bank run"
A bank run is a banker's nightmare, and it is the ultimate manifestation of liquidity risk. It is not a mythical phenomenon; bank runs have happened in history on many occasions, and not many countries have escaped the experience.
Normally, banks' portfolios are structured to deal with customary withdrawals of deposits and utilization of loan commitments, and they plan ahead in order to cope with abnormal seasonal disturbances such as the huge demand for bank notes over the holiday seasons (particularly December/January in the southern hemisphere July/August in the northern hemisphere).
Large non-seasonal withdrawals of deposits can occur for a number of reasons:
• A sharp fall in a bank's profits, triggering concerns about the solvency of the bank.
• Loss of faith in the banking system in general.
• Rumours about the solvency of a bank.
• During the Great Depression (1929-1933) a mere queue outside a bank could have started a bank panic, and a run on the bank.
Some commentators add reasons such as marked changes in investor preferences, for example a positive shift in demands for treasury bills, away from bank deposits. We do not see this as a major reason, because the treasury bill will most likely be sourced from the banks themselves. It will be apparent that this amounts simply to bank disintermediation.
At the centre of the bank run are demand deposits and liquid assets. If the ratio of liquid assets to demand deposits is low, a bank run can be difficult. But the most important condition here is the standing of the bank. As we have said, a bank deposit lost is a bank deposit gained by another bank, and normally it flows back to the deficit bank in the interbank market. This is the norm when banks are of good standing and reputation. If this is not the case, interbank funds are not forthcoming.
This is where the central bank enters the picture.
The central bank and the bank run
As said, in the event of a bank run on a bank with a poor reputation, no other banks will provide the beleaguered bank with interbank loans. The bank will have no option but to approach the central bank for assistance (in its function as the lender of last resort).
The central bank will have a dilemma: does it assist the bank with loans in order for the bank to meet the demand for funds or does it allow the bank to fail? Usually, the central bank will base its decision on whether the failure of the bank will lead to a contagion effect, i.e. that the banking system will be in jeopardy (systemic failure, the nightmare of a central banker).
Central banks in most countries have allowed a number of smaller banks to fail, and, in some cases, a larger bank - but only when it does not fear systemic failure. In cases where it does, or when the relevant bank is solvent, but has a short term problem based on an unfounded bad rumour, it will support the bank.
Deposit insurance, i.e. insurance in terms of which depositors are protected against the failure of a bank, is an effective method to prevent bank runs. There is no reason for a client to panic and demand his/ her funds when a rumour arises about the solvability of a bank.
Deposit insurance is controversial. The prime line of reasoning from the detractors is that deposit insurance is more of a cause of bank failures than the solution. The logic presented is that deposit insurance may encourage bankers to engage in more risky ventures.