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.
Need for Liquidity
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.
How Can a Bank Achieve Liquidity
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 −
- Shorten asset maturities
- Improve the average liquidity of assets
- Lengthen
- Liability maturities
- Issue more equity
- Reduce contingent commitments
- Obtain liquidity protection
Shorten asset maturities
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.
Improve the average liquidity of assets
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.
Lengthen liability maturities
The longer duration of a liability, the less it is expected that it will mature while a bank is still in a cash crunch.
Issue more equity
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.
Reduce contingent commitments
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.
Obtain liquidity protection
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.
Liquidity Management Theory
There are probable contradictions between the objectives of liquidity, safety and profitability when linked to a commercial bank. Efforts have been made by economists to resolve these contradictions by laying down some theories from time to time.
In fact, these theories monitor the distribution of assets considering these objectives. These theories are referred to as the theories of liquidity management which will be discussed further in this chapter.
Commercial Loan Theory
The commercial loan or the real bills doctrine theory states that a commercial bank should forward only short-term self-liquidating productive loans to business organizations. Loans meant to finance the production, and evolution of goods through the successive phases of production, storage, transportation, and distribution are considered as self-liquidating loans.
This theory also states that whenever commercial banks make short term self-liquidating productive loans, the central bank should lend to the banks on the security of such short-term loans. This principle assures that the appropriate degree of liquidity for each bank and appropriate money supply for the whole economy.
The central bank was expected to increase or erase bank reserves by rediscounting approved loans. When business started growing and the requirements of trade increased, banks were able to capture additional reserves by rediscounting bills with the central banks. When business went down and the requirements of trade declined, the volume of rediscounting of bills would fall, the supply of bank reserves and the amount of bank credit and money would also contract.
Advantages
These short-term self-liquidating productive loans acquire three advantages. First, they acquire liquidity so they automatically liquidate themselves. Second, as they mature in the short run and are for productive ambitions, there is no risk of their running to bad debts. Third, such loans are high on productivity and earn income for the banks.
Disadvantages
Despite the advantages, the commercial loan theory has certain defects. First, if a bank declines to grant loan until the old loan is repaid, the disheartened borrower will have to minimize production which will ultimately affect business activity. If all the banks pursue the same rule, this may result in reduction in the money supply and cost in the community. As a result, it makes it impossible for existing debtors to repay their loans in time.
Second, this theory believes that loans are self-liquidating under normal economic circumstances. If there is depression, production and trade deteriorate and the debtor fails to repay the debt at maturity.
Third, this theory disregards the fact that the liquidity of a bank relies on the salability of its liquid assets and not on real trade bills. It assures safety, liquidity and profitability. The bank need not depend on maturities in time of trouble.
Fourth, the general demerit of this theory is that no loan is self-liquidating. A loan given to a retailer is not self-liquidating if the items purchased are not sold to consumers and stay with the retailer. In simple words a loan to be successful engages a third party. In this case the consumers are the third party, besides the lender and the borrower.
Shiftability Theory
This theory was proposed by H.G. Moulton who insisted that if the commercial banks continue a substantial amount of assets that can be moved to other banks for cash without any loss of material. In case of requirement, there is no need to depend on maturities.
This theory states that, for an asset to be perfectly shiftable, it must be directly transferable without any loss of capital loss when there is a need for liquidity. This is specifically used for short term market investments, like treasury bills and bills of exchange which can be directly sold whenever there is a need to raise funds by banks.
But in general circumstances when all banks require liquidity, the shiftability theory need all banks to acquire such assets which can be shifted on to the central bank which is the lender of the last resort.
Advantage
The shiftability theory has positive elements of truth. Now banks obtain sound assets which can be shifted on to other banks. Shares and debentures of large enterprises are welcomed as liquid assets accompanied by treasury bills and bills of exchange. This has motivated term lending by banks.
Disadvantage
Shiftability theory has its own demerits. Firstly, only shiftability of assets does not provide liquidity to the banking system. It completely relies on the economic conditions. Secondly, this theory neglects acute depression, the shares and debentures cannot be shifted to others by the banks. In such a situation, there are no buyers and all who possess them want to sell them. Third, a single bank may have shiftable assets in sufficient quantities but if it tries to sell them when there is a run on the bank, it may adversely affect the entire banking system. Fourth, if all the banks simultaneously start shifting their assets, it would have disastrous effects on both the lenders and the borrowers.
Anticipated Income Theory
This theory was proposed by H.V. Prochanow in 1944 on the basis of the practice of extending term loans by the US commercial banks. This theory states that irrespective of the nature and feature of a borrower’s business, the bank plans the liquidation of the term-loan from the expected income of the borrower. A term-loan is for a period exceeding one year and extending to a period less than five years.
It is admitted against the hypothecation (pledge as security) of machinery, stock and even immovable property. The bank puts limitations on the financial activities of the borrower while lending this loan. While lending a loan, the bank considers security along with the anticipated earnings of the borrower. So a loan by the bank gets repaid by the future earnings of the borrower in installments, rather giving a lump sum at the maturity of the loan.
Advantages
This theory dominates the commercial loan theory and the shiftability theory as it satisfies the three major objectives of liquidity, safety and profitability. Liquidity is settled to the bank when the borrower saves and repays the loan regularly after certain period of time in installments. It fulfills the safety principle as the bank permits a relying on good security as well as the ability of the borrower to repay the loan. The bank can use its excess reserves in lending term-loan and is convinced of a regular income. Lastly, the term-loan is highly profitable for the business community which collects funds for medium-terms.
Disadvantages
The theory of anticipated income is not free from demerits. This theory is a method to examine a borrower’s creditworthiness. It gives the bank conditions for examining the potential of a borrower to favorably repay a loan on time. It also fails to meet emergency cash requirements.
This theory was developed further in the 1960s. This theory states that, there is no need for banks to lend self-liquidating loans and maintain liquid assets as they can borrow reserve money in the money market whenever necessary. A bank can hold reserves by building additional liabilities against itself via different sources.
These sources comprise of issuing time certificates of deposit, borrowing from other commercial banks, borrowing from the central banks, raising of capital funds through issuing shares, and by ploughing back of profits. We will look into these sources of bank funds in this chapter.
Time Certificates of Deposits
These deposits have different maturities ranging from 90 days to less than 12 months. They are transferable in the money market. Thus, a bank can have connection to liquidity by selling them in the money market. But this source has two demerits.
First, if during a crisis, the interest rate layout in the money market is higher than the ceiling rate set by the central bank, time deposit certificates cannot be sold in the market. Second, they are not reliable source of funds for the commercial banks. Bigger commercial banks have a benefit in selling these certificates as they have large certificates which they can afford to sell at even low interest rates. So the smaller banks face trouble in this respect.
Borrowing from other Commercial Banks
A bank may build additional liabilities by borrowing from those banks that have excess reserves. But these borrows are only for a very short time, that is for a day or at the most for a week.
The interest rate of these types of borrowings relies on the controlling price in the money market. But borrowings from other banks are only possible when the economic conditions are normal economic. In abnormal times, no bank can afford to grant to others.
Borrowing from the Central Bank
Banks also build liabilities on themselves by borrowing from the central bank of the country. They borrow to satisfy their liquidity requirements for short-term and by discounting bills from the central bank. But these types of borrowings are comparatively costlier than borrowings from other sources.
Raising Capital Funds
Commercial banks hold funds by distributing fresh shares or debentures. But the availability of funds through these sources relies on the volume of dividend or interest rate which the bank is prepared to pay. Basically banks are not prepared to pay rates more than paid by manufacturing and trading enterprises. Thus they fail to get enough funds from these sources.
Ploughing Back Profits
The ploughing back of its profits is considered as an alternative source of liquid funds for a commercial bank. But how much it can obtain from this source relies on its rate of profit and its dividend policy. Larger banks can depend on these sources rather than the smaller banks.
Functions of Capital Funds
Generally, bank capital comprises of own sources of asset finances. The volume of capital is equivalent to the net assets worth, marking the margin by which assets outweigh liabilities.
Capital is expected to secure a bank from all sorts of uninsured and unsecured risks suitable to transform into losses. Here, we obtain two principle functions of capital. The first function is to capture losses and the second is to establish and maintain confidence in a bank.
The different functions of capital funds are briefly described in this chapter.
The Loss Absorbing Function
Capital is required to permit a bank to cover any losses with its own funds. A bank can keep its liabilities completely enclosed by assets as long as its sum losses do not deplete its capital.
Any losses sustained minimize a bank’s capital, set off across its equity products like share capital, capital funds, profit-generated funds, retained earnings, relying on how its general assembly decides.
Banks take good care to fix their interest margins and other spreads between the income derived from and the price of borrowed funds to enclose their ordinary expenses. That is why operating losses are unlikely to subside capital on a long-term basis. We can also say that banks with a long and sound track record owing to their past efficiency, have managed to produce enough amount of own funds to easily cope with any operating losses.
For a new bank without much of a success history, operating losses may conclude driving capital below the minimum level fixed by law. Banks run a probable and greater risk of losses coming from borrower defaults, rendering some of their assets partly or completely irrecoverable.
The Confidence Function
A bank may have sufficient assets to back its liabilities, and also adequate capital power which balances deposits and other liabilities by assets. This generates a financial flow in the ordinary course of banking business. Here, it is an important necessity that a bank’s capital covers its fixed investments like fixed assets, involving interests in subsidiaries. These are used in its business operation, which basically generate no financial flow.
If the cash flow generated by assets falls short of meeting deposit calls or other due liabilities, it is not difficult for a bank with sufficient capital backing and credibility to get its missing liquidity on the interbank market. Other banks will not feel uncomfortable lending to it, as they are aware of the capacity to conclude its liabilities with its assets.
This type of bank can withstand a major deposit flight and refinance it with interbank market borrowings. In banks with a sufficient capital base, anyhow, there is no reason to fear a mass-scale depositor exodus. The logic is that the issues which may trigger a bank capture in the first place do not come in the limelight. An alternating pattern of liquidity with lows and highs is expected, with the latter occurring at times of asset financial inflow outstripping outflow, where the bank is likely to lend its excess liquidity.
Banks are restricted not to count on the interbank market to clarify all their issues. In their own interest and as expected by bank regulators, they expect to match their assets and liability maturities, something that permits them to sail through stressful market situations.
Market rates could be affected due to the intervention of Central Bank. There can be many factors contributing to it like the change in monetary policy or other factors. This could lead to an increase in market rates or the market may collapse. Depending upon the market problem the banks may have to cut down the client lines.
The Financing Function
As deposits are unfit for the purpose, it is up to capital to provide funds to finance fixed investments (fixed assets and interests in subsidiaries). This particular function is apparent when a bank starts up, when money raised from subscribing shareholders is used to buy buildings, land and equipment. It is desirable to have permanent capital coverage for fixed assets. That means any additional investments in fixed assets should coincide with a capital rise.
During a bank’s life, it generates new capital from its profits. Profits not distributed to shareholders are allocated to other components of shareholders’ equity, resulting in a permanent increase. Capital growth is a source of additional funds used to finance new assets. It can buy new fixed assets, loans or other transactions. It is good for a bank to place some of its capital in productive assets, as any income earned on self-financed assets is free from the cost of borrowed funds. If a bank happens to need more new capital than it can produce itself, it can either issue new shares or take a subordinated debt, both an outside source of capital.
The Restrictive Function
Capital is a widely used reference for limits on various types of assets and banking transactions. The objective is to prevent banks from taking too many chances. The capital adequacy ratio, as the main limit, measures capital against risk-weighted assets.
Depending on their respective relative risks, the value of assets is multiplied by weights ranging from 0 to 20, 50 and 100%. We use the net book value here, reflecting any adjustments, reserves and provisions. As a result, the total of assets is adjusted for any devaluation caused by loan defaults, fixed asset depreciation and market price declines, as the amount of capital has already fallen due to expenses incurred in providing for identified risks. That exposes capital to potential risks, which can lead to future losses if a bank fails to recover its assets.
The minimum required ratio of capital to risk-weighted assets is 8 percent. Under the applicable capital adequacy decree, capital is adjusted for uncovered losses and excess reserves, less specific deductible items. To a limited extent, subordinated debt is also included in capital. The decree also reflects the risks contained in off-balance sheet liabilities.
In the restrictive function context, it is the key importance of capital and the precise determination of its amount in capital adequacy calculations that make it a good base for limitations on credit exposure and unsecured foreign exchange positions in banks. The most important credit exposure limits restrict a bank’s net credit exposure (adjusted for recognizable types of security) against a single customer or a group of related customers at 25% of the reporting bank’s capital, or at 125% if against a bank based in Slovakia or an OECD country. This should ensure an appropriate loan portfolio diversification.
The decree on unsecured foreign exchange positions seeks to limit the risks caused by exchange rate fluctuations in transactions involving foreign currencies, capping unsecured foreign exchange positions (the absolute difference between foreign exchange assets and liabilities) in EUR at 15% of a bank’s capital, or 10% if in any other currency. The total unsecured foreign exchange position (the sum of unsecured foreign exchange positions in individual currencies) must not exceed 25% of a bank’s capital.
The decree dealing with liquidity rules incorporates the already discussed principle that assets, which are usually not paid in banking activities, need to be covered by capital. It requires that the ratio of the sum of fixed investments (fixed assets, interests in subsidiaries and other equity securities held over a long period) and illiquid assets (less readily marketable equity securities and nonperforming assets) to a bank’s own funds and reserves not exceed 1.
Owing to its importance, capital has become a central point in the world of banking. In leading world banks, its share in total assets/liabilities moves between 2.5 and 8 %. This seemingly low level is generally considered sufficient for a sound banking operation. Able to operate at the lower end of the range are large banks with a quality and well-diversified asset portfolio.
Capital adequacy deserves constant attention. Asset growth needs to respect the amount of capital. Eventually, any problems a bank may be facing will show on its capital. In commercial banking, capital is the king.
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