Liquidity Provision

3 Key excerpts on "Liquidity Provision"

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  eBook - PDF

  Interest Rates, Prices and Liquidity

  Lessons from the Financial Crisis

  • Jagjit S. Chadha, Sean Holly(Authors)
  • 2011(Publication Date)
  • Cambridge University Press

    (Publisher)

  One is the payment of interest on liquid balances or reserves, essentially a Pigovian subsidy on liquidity. This would encour- age the accumulation of liquid balances that can then be run down when profitable opportunities arise. Another is the creation of liquidity facilities by the central bank, essentially an extension of its role as lender of last resort. A third would be the introduction of some sort of liquidity insur- ance, in effect an attempt to replicate the complete markets of the first model we looked at. A fourth would be to include measures of (il)liquidity in the capital adequacy standards of future versions of the Basel accords. For example, capital ratios might be linked to measures of maturity mismatch, such as the ratio of average maturities of assets to liabilities. 50 Interest Rates, Prices and Liquidity The greater the maturity mismatch between assets and funding liabilities, the greater the amount of capital that would be required. Similar adjust- ments to capital requirements could be made for relying on core deposits instead of wholesale or market funding. The advantage of this approach is that it imposes a cost to illiquidity that gives the bank an incentive to manage its liquidity prudently, without imposing strict ratios. The capital ratio itself is still a constraint, however. How well these alternatives will work is beyond the scope of this chapter, but they all deserve further study. 4 Liquidity Provision in a crisis We argued above that there may be an inadequate level of liquidity in the financial system when markets are incomplete. This conclusion is con- sistent with the view of Goodfriend and King (1988) that, under normal conditions, financial markets allocate liquidity efficiently. So, under nor- mal conditions, the job of the central bank is to ensure adequate liquidity in the system as a whole. In a crisis, however, providing adequate liquidity in the aggregate may not be enough.

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  Commercial and Investment Banking and the International Credit and Capital Markets

  A Guide to the Global Finance Industry and its Governance

  • B. Scott-Quinn(Author)
  • 2020(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  By selling government securities that it is holding, i.e. obtaining liquidity by using a market to sell its assets (market liquidity), these liquid assets should enable a bank to repay depositors on demand even if its reserves at the central bank are temporarily insufficient due to sudden demand. However, if all depositors demand that their deposits be returned in the form of notes and coin, or that all their deposits be transferred to other banks (which is effected through the transfer of deposits via the central bank), the bank 6 This is the theorem that describes the likely outcome of performing the same experi- ment a large number of times. The law predicts that the average of the results obtained from a large number of trials should be close to the expected value. Not only that but it will become closer as more trials are performed. In the case of bank lending it allows the use of the ‘expected loss’ concept based on historical losses on similar portfolios of assets. If it always held, it would ‘guarantee’ stable long-term results for random events. However, in practice events are often not as random as we believe and therefore the outcome may be much higher or lower than the expected value. LIQUIDITY: WHAT IS IT? 85 would suffer a bank run. An example of this was the run on Northern Rock Bank in the UK in 2007, the first run on a bank in the UK since 1878. 7 FUNDING (BORROWER) LIQUIDITY Liquidity is often explained as the ability to convert a financial asset such as shares into cash at minimum cost and with minimum loss of value, which is how we analysed it in the section above. In turn, cash is something that is universally accepted in exchange for goods and services. This is only one concept of liquidity, known as market liquidity or investor liquidity; it is relevant for assets being sold in a secondary market.

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  The Liquidity Risk Management Guide

  From Policy to Pitfalls

  • Gudni Adalsteinsson(Author)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  As the oldest and most fundamental role of banks is to be an institution for maturity transformation one would expect a general acceptance and understanding of the function they provide. However, as we touched upon in Chapter 1, this seems from time to time to get forgotten and banks have been criticized and even stamped ‘reckless’ by borrowing short and lending long. As will be discussed in more detail in later chapters, not all short-term funding can be seen as the most risky funding available and there are multiple other factors at play.

  4.1.1 Liquidity – Definition

  There is a lack of general consensus on how to identify liquidity and no generally accepted, single definition of the term ‘liquidity’ is to be found. The simplest form of definition would be to define liquidity as the ability to obtain cash when needed.2 Consequently, liquidity can be created by borrowing or converting assets to cash.

  Defining liquidity only as a ‘stock’ of funds does not fully capture all of its attributes. One can also define liquidity as a way to buy time, focusing on the time value of liquidity. This indicates that liquidity is not only a one-dimensional concept solely determined by quantity (an amount) but as importantly is a function of time; that is it matters to have the liquidity when needed, as stated above. As every liability and asset on the balance sheet is not only a ‘stock’ amount but rather a bundle of incoming and outgoing cash flows, we need to define liquidity in terms of time. This is usually the way liquidity is expressed in a bank. For instance, a financial institution is commonly said to hold a number of days of liquidity, meaning the institution has enough liquidity sources to cover a certain number of days of scheduled outflows. This expression is useful to the reader as it provides information about liquidity in measures of time, whereas a statement asserting a bank has $100m of liquidity is not a meaningful measurement.

  This leads us to the conclusion that liquidity has a quantity as well as a time aspect – both equally important. Figure 4.1 helps to further understand the liquidity concept.

  Figure 4.1

  Sources of liquidity3

  Liquidity can be seen as a tank of money, which increases when money comes in and decreases when funds exit the tank. A bank has a liquidity reserve (a quantity) to meet its outflows (liquidity out), which can either be repayment of outstanding liabilities or the provision of loans. The liquidity reserve builds up by adding new liquidity (liquidity in), which could be in the form of deposits placed with the bank, bond issuance or repayment from its loan portfolio. The quantity in the tank gives a good indication of the liquidity of the bank, but the amount and timing of inflows and outflows are equally important. A small amount of outflow means the tank can support the bank for a long period of time whereas large outflows will make the bank quickly run out of funds. However, it is not only the amount of outflows that is the determining factor. The amount and timing of inflows add to the amount in the tank. We therefore determine liquidity as a combination of the stock (i.e. the liquidity reserve) and the net cash flows.

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