Capital vs Liquidity

Topics: Debt, Capital requirement, Basel II Pages: 9 (2695 words) Published: March 12, 2012
Liquidity, liquidity, liquidity…..
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 quite sophisticated. International banks can trade with each other very efficiently using many products. • Straight loans and deposits, simple products of fixed term from overnight up to 1 year. Usually not guaranteed. • Bond repurchase agreements (repos), banks borrow cash and pledge a bond as security against the loan. More secure for the lender than loans and therefore cheaper for the borrower. • Foreign exchange forwards, involves the exchange of one currency for another for a fixed term. These are cleared centrally and will have a small element of credit risk. These are useful if an organisation is able to access one currency and unable to source another, e.g. the US dollar funding requirements of Irish Banks. • Commercial Paper (CP) and Certificates of Deposit (CD’s) are similar to a cash loans but it can be sold on in the secondary market. This makes them more liquid.

All of the above are used to “square up” a bank’s books on a daily basis. Also banks run gap analysis to reconcile any funding mismatches and close off those gaps if required. This is called liability management. The funding situation would generally have been very fluid. For example, CD’s issued on the day or a large corporate withdrawing a sizeable deposit. The interbank market was the place to lend your excess cash or borrow your shortage and it functioned effectively.

This post World War II move to asset driven balance sheets has led to increased focus on liability management. This, aligned with disintermediation, where large corporates bypassed traditional banking methods, led to more innovation in the banking industry.

Medium Term Notes (MTNs) and asset securitisation are longer term funding solutions that became more popular in recent times. MTNs can be senior or subordinated debt and are quite flexible for issuer and investor. They usually are for 3 to five years and some may have embedded options. They can have fixed or floating rates and trade on the secondary...
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