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Liquidity requirements

Liquidity requirements


Regarding to figure out how to stop banks failing it helps to start with an understanding of why they fail. There’s two basic risks that banks need to watch out for – (i) solvency and (ii) liquidity.

Liquidity issues arise as a result of banks undertaking maturity transformation, which is obtaining short term deposits from market and lending them out in form of long term assets like loans, investments into Bonds etc. Customers want to deposit their funds with banks and earn a positive interest rate whilst being able to withdraw the funds again at short notice, whenever they need them. Borrowers need long term loans to purchase property and equipment for their personal or corporate uses. In the area of relatively low interest rates it’s even worse situation as banks also have almost no LT-funds available (most of the deposits are due at sight), however funding needs to provide mortgage or investment loans are still of long term nature.

Banks provide in fact a service to the economy by bridging the gap between the available excess of liquidity and needs for financing. Nevertheless, it is in the interest of each Bank to properly manage this Liquidity gap (stemming from different maturities of liabilities and corresponding assets), as in case of any damaged reputation the Bank may face the run on deposits (withdrawing them), which will then result into payment illiquidity and Bankruptcy (if no external of government assistance is provided quickly).

As a consequence of the above mentioned Basel III introduced two required liquidity ratios:

a) Liquidity coverage ratio (LCR)

This ratio measures the amount of highly liquid assets relative to liabilities coming due over the next 30 days. There are adjustments to both the numerator and the denominator for the perceived quality of the assets (cash, central bank deposits, bonds) and liabilities (at call deposits, wholesale funding). Banks need to maintain the ratio above 100%, which theoretically implies that they are able to meet their maturity liabilities. Banks can increase their liquidity coverage ratio by increasing the proportion of highly liquid assets they hold (less loans and more cash) or by increasing the length of the funding they receive from retail depositors (term deposits instead of at-call accounts) and wholesale providers (medium term bonds instead of bank bills).

b) Net Stable Funding ratio (NSFR)

The net stable funding ratio is a liquidity standard requiring banks to hold enough stable funding to cover the duration of their long-term assets. For both funding and assets, long-term is mainly defined as more than one year, with lower requirements applying to anything between six months and a year to avoid a cliff-edge effect. Banks must maintain a ratio of 100% to satisfy the requirement.
The NSFR has become a minimum standard by 1 January 2018. However, implementation has been delayed in many countries.

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