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Why do banks need liquidity?

By Jenal Mehta

13:04, 28 February 2022

Person at automated teller machine
Liquidity refers to the ability to pay planned payments, or meet demand for funds, without incurring high costs – Photo: Shutter Stock

Banks are an essential part of the financial eco-system. Their collapse can have a cascading effect on the rest of the economy.

A bank’s ability to be able to meet its payments and withdrawal demands is how it remains liquid, reducing the risk of bankruptcy.

Due to banks being interconnected, the downfall of one bank can quickly spread throughout the economy. This was evident during the financial crash of 2008. After which, liquidity regulations came into place to ensure better liquidity management and to provide a framework for banks to absorb abnormal shocks.

Although some shocks cannot be foreseen, as evident by the potential failure of Sberbank announced by the European Central Bank (ECB).

What is bank liquidity?

A bank’s liquidity refers to its ability to pay its planned payments, or meet demand for funds, all without incurring high costs. This can include paying back loans or having enough funds to meet withdrawal demands.

A bank’s main business operation is to provide funding from which it earns interest income, and investing deposits from which it earns investment returns.

Due to banks’ lending among themselves, a single bank’s poor liquidity can quickly spill over onto other banks. The reason behind these interbank loans is explained by the Bank Policy Institute:

“Banks deal with their inherent illiquidity first and foremost through borrowing and lending in the interbank market. At any given point in time, some banks will need liquidity while others will have extra and liquidity is distributed between then using short term, typically overnight loans.”

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-0.180% 1D Chg, %
Long position overnight fee -0.0191%
Short position overnight fee 0.0109%
Overnight fee time 21:00 (UTC)
Spread 0.60

BTC/USD

57,987.10 Price
+0.480% 1D Chg, %
Long position overnight fee -0.0616%
Short position overnight fee 0.0137%
Overnight fee time 21:00 (UTC)
Spread 106.00

US100

20,336.40 Price
+0.570% 1D Chg, %
Long position overnight fee -0.0263%
Short position overnight fee 0.0040%
Overnight fee time 21:00 (UTC)
Spread 7.0

XRP/USD

0.48 Price
+6.970% 1D Chg, %
Long position overnight fee -0.0753%
Short position overnight fee 0.0069%
Overnight fee time 21:00 (UTC)
Spread 0.01168

Poor returns on deposit investment, or high costs of borrowing on the interbank market, poor interest income from loans and rapid withdrawals by depositors can eat away at a bank’s profits, effecting its liquidity.

Risks of poor liquidity

The financial crisis of 2008 was a prime example of how poor liquidity management can have a contagion effect across the wider economy. There were many systemic failures in place to create the perfect storm, one of them was how the banking system managed its liquidity. This liquidity contraction eventually spread across the global financial market.

Recently due to geopolitical tensions, Sberbank Europe, a subsidiary of Sberbank Russia, was found to be likely to fail per the ECB due to its inability to pay its liabilities. This comes after increased outflow of deposits deteriorating its liquidity.

Liquidity requirements

A bank should have a frame work in place to withstand any kind of adverse events which may negatively affect its liquidity. This is known as liquidity management.

Maintaining a sufficient level of cash or other liquid assets is an important aspect of managing liquidity risk. Healthy banks, in fact, tend to keep these levels higher than what is required. The ECB defines this as “excess liquidity”.

The financial crisis of 2008 was a catalyst in allowing excess liquidity to exist within the banking system. Before this, liquidity was more or less matched exactly to needs. The ECB outlines since 2008, the euro area banking system has switched to a full allotment system. Banks can borrow as much as they want from the central bank as long as they have collateral to match it.

The Basel Framework was also formed in response to reforming banking regulation after the crisis, which created the first global liquidity standards. This requires banks to maintain a certain level of leverage cover and certain levels of reserve capital on hand based on their size. These are voluntary requirements.

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The main difference between CFD trading and trading assets, such as commodities and stocks, is that you don’t own the underlying asset when you trade on a CFD.
You can still benefit if the market moves in your favour, or make a loss if it moves against you. However, with traditional trading you enter a contract to exchange the legal ownership of the individual shares or the commodities for money, and you own this until you sell it again.
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