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Liquidity

Liquidity

How can banks generally fulfill their obligations in a system in which the amount of money that clients may require is always smaller than the amount that the banks actually have?

There are different ways to manage liquidity:

  • maintaining a money stock not less than a specific share of clients’ funds,
  • monitoring clients’ behaviors to determine the cash amount that continuously remains unclaimed on the accounts,
  • analyzing concentration of clients’ accounts, i.e. presence of major depositors whose cash outflow can significantly undermine the bank’s liquidity,
  • drawing charts of expected inflows and payments based on the correlation between maturity of granted loans and the deposits funding them, or
  • selling a part of bank’s assets, or attracting funds from other banks to fill the temporary need of cash, as well as other techniques.

 

All these methods are based on the assumption of some “normal” functioning of the banking system that implies stable balances on clients’ accounts and a predictable schedule of loan repayments and payments on deposits and accounts. Using this concept of “normality” as a tool, one can call any situation a crisis—such as when bank clients withdraw their funds to a larger extent than anticipated, and/or bank borrowers stop paying on time, preventing the bank from making timely payments on deposits—therefore exonerating the banking system from any responsibility for its systemic instability.

However, all the situations listed above are absolutely natural. Clients have the right to come for their money whenever they want and not whenever the bank plans it. Moreover, which is thoroughly evident, any borrower’s business may not turn out to be successful enough to ensure loan repayment exactly according to the loan terms: any business is risky by definition, and nonrepayment of loans is simply inevitable and unpredictable. No matter what sophisticated methods banks use, life itself has shown and continues to show that within the existing system, they are unable to manage liquidity without help from the government. The fractional-reserve banking system is crisis-prone by its nature due to its internal tension; all measures taken today to support it only cure the symptoms instead of the disease. Let us consider these measures taken to support the banking system:

Solution 1 – Refinancing with the CB

The Central Bank is usually called a creditor in the last resort. If a bank lacks funds to fulfill its current liabilities, it has the right to appeal to the CB, which can issue money, filling ordinary banks’ accounts with real cash. Therefore, the presence of unreserved client accounts created by banks during the money-issuing process forces the CB to issue its own money in order to maintain the existence of the system. Without support from the CB, the fractional-reserve banking system cannot work.

The Central Bank provides funds in two ways:

– by lending money to banks,

– by purchasing assets from banks.

Bank lending by the Central Bank

You might remember that we have already discussed the CB’s money-creating method such as credit emission. Now we can see clearly in which situations the method is used. Suppose a commercial bank is suddenly visited by all of its clients who claim all the 100 units of cash that belong to them. The CB will support the bank by lending the money and making the following entry in its balance:

Due from banks Account of Bank opened with the CB

100 units

100 units

Immediately upon receipt of the loan from the CB, the picture on the commercial bank’s balance will look as follows:

Cash in vault Due to the Central Bank

120 units

100 units

Investments Customer accounts

180 units

100 units

Capital

 

100 units

 

After its liabilities to the claiming mass of clients are repaid, the bank’s balance will look as follows:

 

 

Cash in vault Due to Central Bank

20 units

100 units

Investments Capital

180 units

100 units

 

In this way, the money created by the fractional-reserve banking system, aided by the refinancing mechanism, has turned into cash, i.e., money created by the government.

Please also note that upon receipt of the CB loan, the ordinary bank becomes a sort of intermediary between the Central Bank and its own borrowers: it must use the money received from them as loan repayment to repay its own loan to the CB. That is, the CB actually becomes an indirect creditor of the commercial bank’s borrowers.

Asset purchase by the Central Bank

In some cases, the CB may not only lend funds to a bank, but purchase its assets and put them directly on its books:

 

Assets purchased from the Bank Account of Bank opened with the CB

100 units

100 units

 

Immediately upon the asset purchase by the Central Bank, the picture on the commercial bank’s balance will look as follows:

Cash in vault Customer accounts

120 units

100 units

Investments Capital

80 units

100 units

 

After its liabilities to the clients are repaid, the bank’s balance will look as follows:

Cash in vault Capital

20 units

100 units

Investments

80 units

 

 

The method of buying assets from commercial banks is called quantitative easing. As a rule, the CB buys out top-quality investments such as government bonds and bonds secured by mortgages. Unlike bank lending, when the CB buys out assets it becomes a direct, rather than indirect, investor, taking all the risks upon itself and therefore leaving the bank with its “risk-free” capital and hence with an opportunity to continue creating new money.

Solution 2 – Government Support

In more serious cases, the problem is that a bank’s assets are insufficient to fulfill its obligations to its clients. In other words, the bank goes bankrupt. This is a situation in which a bank ends up with negative economic capital: it is unable to repay its obligations not only due to a temporarily insufficient current stock level, but because its property is not enough for that in general.

But even in this case, most countries have a mechanism protecting money of such banks’ clients. This mechanism is represented by explicit and implicit government support of the banking system.

The explicit form consists of establishment of specific insurance entities. Deposit insurance corporations charge all banks to collect funds from which they pay clients of bankrupt banks. Different jurisdictions use different operating principles for such funds: almost all countries restrict the size of compensation that any single client may get, but this amount varies significantly in different countries; some governments insure only private investors’ funds, while others also cover corporate money, etc. Deposit insurance funds usually begin working once a bank’s bankruptcy has been officially declared, and they compensate for losses on insured deposits only.

In addition to official deposit insurance institutions, the government also provides implicit support to major banks whose bankruptcy may lead to systemic economic risks. Such banks are just too big to fail; to most clients’ minds, they are reliable because it is expected that the government will support them in times of trouble. These expectations are corroborated by specific government actions. Thus, many governments became shareholders of major banks during the financial crisis, increasing their capital and keeping them afloat. Citibank was saved by the government of the United States, Royal Bank of Scotland was supported by the government of the United Kingdom, Dexia was bailed out by France and Belgium and this is not a complete list.

This support has become possible due to the steep increase in national debts incurred to support the financial system in distress.

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