Bank’s liquidity: How can they solve the problem of liquidity?
It is common knowledge that banks always had a principal role in all contemporary financial systems. The basic part of them, commonly, is the change of fluid store liabilities into illiquid resources, for example, loan; this makes banks by and large defenceless against the liquidity risk. Due to the potential risks in the 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. The Basel Committee on Banking Supervision (2008a) describe the liquidity as “the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses”. In other words, we could define that liquidity is assuring access to cash when it is needed. Bank’s liquidity is about the confidence of counterparties and depositors in the institution and its perceived solvency or capital adequacy. Banks have to meet regulations, so liquidity risk should be in balance and one way to succeed this is by the management of liquidity risk. This risk tries to secure a bank’s ability to carry out this fundamental role.
After the global financial turmoil (2008) many banks were left affected in a negative way because they could not follow the agreement to fund liquidity and their ability to do business in financial markets without causing important price impact (market liquidity) led to the condition that weakens liquidity and put in danger the global financial stability. There were two important trends that supported the easily broken funding framework at some banks, before the financial crisis. Firstly, instead of stable retail deposits or longer-term debt, there was a rising dependence on short-term wholesale funding. Secondly, banks collected large amounts of assets that turned out to be less liquid than anticipated especially the securitized debt instruments, such as collateralized debt obligations and residentials mortgage-backed securities. In demanded market conditions, banks could not convert into collateral these assets in nonpublic markets. After the above-mentioned problems, the Basel Committee developed the liquidity coverage ratio (LCR), which is to encourage the endurance of bank liquidity and restrict the need for public aid, and the net stable funding ratio (NSFR), which is created to advertise a more stable funding profile regarding to the maturity profile of assets, decreasing the prior of banks to funding-liquidity risk. The whole this situation central banks are the most reliable provider of liquidity; thus, they are playing a major role in the solvency of banks liquidity.
3 Impact of financial crisis to liquidity risk
Before the credit crisis, the liquidity risk was, for the most part of the world, comprehended. However, maybe it was not completely valued that financial advancement and global market evolutions had changed certain aspects of liquidity risk in essential ways lately. The effects of these improvements turned out to be strikingly obvious during the recent turmoil.
3.1 Dependence on capital markets
In the first place, the subsidising of major banks has moved towards a more prominent dependence on wholesale subsidising (wholesale deposits, repurchase obligations and other currency market instruments) from institutional and corporate speculators (both financial and non-financial)-a commonly more unstable resousrce of subsidizing than conventional retail deposits.
At time of serious market stress, modern wholesale financial specialists tend to display intense hazard avoidance. This was made obvious by the extreme funding issues experienced in 2008 by major U.S. investment banks that had an unstable retail deposit base. At these circumstances At such circumstances, investors can request higher pay for risk and better rebates to collateral assets with doubtful cash flows, demand banks to approve liabilities at greatly shorter developments, or reject to enlarge financing. In these cases, refinancing sources have to be encountered rapidly to supplant the loss of financing.
Many banks had come to depend progressively on securitization as a source of fee income and as an approach to decrease capital and liquidity needs. Nevertheless, amid the recent turmoil, liquidity pressures occurred as some of these banks were obliged to delay some arranged securitizations and confronted a development of warehoused assets that have to be financed. A few types of securitization (i.e., ABCP conductors) offered increase to possible liquidity risk, that is, the need to give liquidity under backstop arrangements, when the supporting bank was under pressure.
3.3 Increasing request for collateral
A third recent trend has been extended interest for high-quality collateral. This pattern is partially to an expansion in the utilization of collateral for vowing purposes to reduce risk (Aaron, Armstrong, and Zelmer 2007) and partially to the altering nature of exchanges between financial firms, including the rose use of repos and derivatives in the wholesale financing markets. Rising requests from as-it-happens payment and settlement frameworks have likewise outstandingly expanded within the day request for collateral.
While the use of security limits counterparty credit risk, it can make financing liquidity worse because counterparties need to give extra collateral at short notice if conditions change. The more generally collateralization is utilized, the more important this hazard turns out to be, particularly as market cost developments in hedged portfolios result in changes in the size of counterparty credit exposures. Amid the ongoing disturbance, deficiencies of superb security rose, inciting extraordinary activities by some central banks.
4. Ways to increase the liquidity
4.1 Shorten asset maturities
There are many ways for banks to increase their liquidity, yet every one of them has a cost.
There are two ways that can be implemented. Firstly, if the maturity of a few resources is abbreviated by enough that they mature amid the time of a money crunch, at that point there is a clearly advantage. Secondly, shorter maturity resources for the most part are more fluid.
4.2 Reduce possible dedications
Decreasing the volume of credit extensions and other possible dedications to pay out money in the future diminishes the potential expenses, enhancing the balance of sources and utilizes of money.
4.3 Enhance the average liquidity of assets
Assets that will mature after the time limit of a real or potential money crunch can still be vital suppliers of liquidity, if they can be sold promptly without an intemperate financial loss. There are many ways that banks can improve asset liquidity. One of these is that securities are generally more liquid than assets and loans, except some large loans that are formed to be easy to vend on the wholesale markets, so this is a matter of degree and not an absolute statement (Douglas J. Eliot, 2014).
After carefully considering the above mentioned points, we could maintain that banks have an essential role to the liquidity. The fundamental role of them, typically, is the process of changing the liquid deposit liabilities into illiquid assets. As a result, banks are generally vulnerable to liquidity risk. Therefore, banks should implement the above solutions in order for the future to increase their liquidity and not to have problems with that. This essay discussed the impact of financial crisis to liquidity risk and provided some solutions in order for banks to obtain adequate liquidity.
Armstrong Jim and Gregory Caldwell. “Liquidity Risk at Banks: Trends and Lessons Learned from the Recent Turmoil”. Bank of Canada (December 2008).
Basel Committee on Banking Supervision. 2008a. “Liquidity Risk: Management and Supervisory Challenges.” Bank for International Settlements (February).
Basel Committee on Banking Supervision. 2008b. “Principles for Sound Liquidity Risk Management and Supervision.” Bank for International Settlements (September).
Douglas J. Elliot. “Bank Liquidity Requirements: An Introduction and Overview”. The Brookings Institution (June 23, 2014).
Tamara Gomes and Carolyn Wilkins. “The Basel III Liquidity Standards: An Update”. Bank of Canada (June 2013).