The Role of Liquidity in Banks

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It’s often argued that credit risk is the single largest risk facing banks. But more banks have failed because of liquidity risk than credit risk. This is because banks are particularly vulnerable to sudden unexpected demands for funds. 

Even if you look at how most banks are in the business of liquidity as they take deposits that are often payable to customers on demand or on notice over a short period. Banks then use it to fund credit facilities to borrowers over longer periods. 

Therefore banks need to be able to meet its obligations to its depositors or other creditors. And not fail due to becoming insolvent or too illiquid to meet its liabilities and as such, the bank being unable to fulfill the demands of all of its depositors on time. 

This may be known as a bank fail. And more specifically, a bank usually fails economically when the market value of its assets declines to a value that’s less than the market value of its liabilities. The insolvent bank either borrows from other solvent banks or sells its assets at a lower price than its market value to generate liquid money to pay its depositors on demand.  

The inability of the solvent banks to lend liquid money to the insolvent bank creates a bank panic among the depositors as more depositors try to take out cash deposits from the bank. As such, the bank is unable to fulfill the demands of all of its depositors on time. Also, a bank may be taken over by the regulating government agency if Shareholders Equity (capital ratios) is below the regulatory minimum.  

The failure of a bank is generally considered to be of more importance than the failure of other types of business firms because of the interconnectedness and fragility of banking institutions. Research has shown that liquidity problems experienced by a particular bank can quickly and easily spread to other banks and cause systemic risk, thereby causing contagion effects across an entire banking system.  

Therefore risk management has to play in the day-to-day management of banks and other institutions. It’s, therefore, important that liquidity risk management be part of banks’ overall risk management strategies. As a result, banking institutions are typically subjected to rigorous regulation. And bank failures are of major public policy concern in countries across the world, example in South Africa the VBS bank.

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