In the context of the events of the last few years just how important is liquidity to the survival and well-being of Financial Institutions? Some believe it has a greater influence on events than Capital! Discuss. (In this assignment you need to outline the role of liquidity, issues arising when liquidity is scarce and compare the role of liquidity to that of Capital but most importantly give your own view on these matters)
Role of Liquidity
Liquidity can be defined as 1) the ability of a business to meet obligations without disposing of its fixed assets or 2) the degree to which assets of a company can be easily converted into cash.
The evolution of banking has seen their balance sheet composition change. The model changed from one of borrowing at low rates and lending high rates with little interest rate or liquidity risk to one where borrowing in the short end and lending in longer maturities. This change created both interest rate risk and liquidity risk.
Figure 1 Liquidity Gap
In the early model a 1 month loan at 8% is matched by a 1 month deposit at 5%. The margin is locked in at 3%. The only risk to the bank is credit risk, i.e. that the loan gets repaid. In the modern scenario we have a 150 day loan at 6% funded by a 7 day deposit at 1%. In this example we have credit risk, interest rate risk and liquidity risk. This model facilitates greater margin as it is generally cheaper to borrow in the short term and higher rates available if lending in the longer term. The risks are that in 7 days, where will the borrowing rate be (rate risk) and will the bank be able to borrow (liquidity risk)?
The hedging of interest rate risk has been made much easier with the development of interest rate swaps and other derivative items. As these are off balance sheet products, they do not provide liquidity and so the modern model is very susceptible to any problems with liquidity.
The interbank cash market is... [continues]
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