Firstly it is necessary to define liquidity and explain the reason that liquidity is so important for banks. Liquidity is essentially immediately spendable funds or the ability to convert assets into spendable funds, quickly and easily without a significant loss.
Banks need liquidity because of demands for spendable funds. These demands mainly come from customers wishing to withdraw money from their accounts and from customers with credit requests, either in the form of new loans or drawings upon existing credit lines. However, banks will also have a demand for liquidity for other reasons including paying off liabilities that they have for example loans from other banks, or the central bank, payment of income taxes, and the paying of cash dividends to their shareholders.
Sources of liquidity that banks have available to them fall into two categories; asset liquidity and borrowed liquidity, with most banks tending to use a mix between them both known as balanced liquidity management. Banks using a balanced liquidity management strategy look at their expected liquidity demands, store some of these demands in liquid assets, and the rest left down to prearranged lines of credit from potential suppliers of funds.
The stock of liquid assets is held by banks solely as a reserve, which can be turned into cash in crisis conditions when a bank cannot meet its financial obligation. These assets must be of high quality so that in times of need, they can be sold immediately with minimal losses. These liquid assets, other than cash, include:
- Commercial paper is issued by large corporations as a form of short-term borrowing. The maturity of commercial paper is in most cases between 7 and 45 days and is sold similarly to the treasury bills, at a discount to its maturity value. Commercial paper is generally unsecured, making it riskier than buying treasury bills. Companies using commercial paper will normally get a credit rating check from a credit rating agency and the better the rating they achieve, the smaller the discount they can issue it at, as it is a more secure investment.
- A certificate of deposit (CD) is a certificate stating that a deposit has been made with a bank for a fixed period of time and that at the end of the fixed term, the original deposit will be repaid with interest. The advantage of CDs for the depositor is that they are tradable to third parties, so the depositor can make use of the funds, if needs be, before the maturity date. The advantage to the financial institution issuing the CD is that they can make use of the deposit for the fixed period, but because they offer the depositor flexibility, the bank gets it for a slightly lower price than they would normally have to pay for other time deposits such as repos. The disadvantage of the CD is that the depositor has to deposit a minimum denomination of £50,000 which means that small companies may not have the money for them.
- Repurchase agreements (Repo’s) are a combination of two transactions, and play a critical role in the money markets. It works by firstly a securities dealer, such as banks, sells securities it owns to an investor and agrees to repurchase them at a specified higher price at a date in the future. This is a great way for dealers to raise funds quickly. For the investor, repo’s can be a very profitable short-term investment. This is because not only will they make money with the dealer buying the securities back at a higher price, but if they believe that the price of the securities will drop, then they can sell them, and then potentially purchase equivalent securities to return to the dealer just before the repo must be unwound. Therefore the investor has potentially made more money on top of the interest earned from the dealer.
- Treasury Bills are securities with a maturity of one year or less and are issued by national governments. These are generally considered to be the safest of all investments, and for this reason, they account for a larger share of money market trading than any other type of instrument. They are also known as zero-coupon bonds, as they do not pay any interest, but instead are bought at a discount rate to their face value, depending on how long it is until the security matures.
The main sources of borrowed liquidity available to banks include:
- The Interbank lending market is a market where banks can lend money to each other. This provides banks with the ability to get funds quickly in times of bad liquidity and also provides an outlet for lending excess funds. The loans are normally short-term loans, generally between 1 and 14 days, but can be longer. The interbank lending market has its own interest rate, called the London Interbank Offered Rate (LIBOR), which is currently stabilized at just over 0.6%, around 10 basis points above the current base rate.
- Euromarkets have been some of the fastest-growing markets in recent years and are basically any instrument denominated in a currency other than that of the country where it is traded. Financial institutions will look for money at the lowest price, regardless of the currency, and then change it into the home currency. This can be a good way of finding cheap money quickly, especially if the interbank lending market has dried up as it has done recently.
- Bond Markets are a great way of getting liquidity as there is a huge market for bonds. Bonds offer the investor interest throughout the life of the bond, and repayment of the original principal at the end. Unlike shares, the owner of the bond does not have any degree of managerial control or ownership of the issuer. For this reason, it is a great way to get liquidity because the issuer is not losing any of the company or institution and therefore none of its powers. The interest rates however must be competitive on the day of the issue but need to be just right as if it is too high, then the issuer could end up with excessive costs, but if it is too low, then they may not be able to sell them.