Why Commercial Banks Should Be Concerned About Liquidity?


liquid cash

Commercial banks are financial institutions that accept deposits, offer loans, and provide other financial services to the general public. Like other institutions, banks are concerned about several things, including debt levels, global economy, inflation, and liquidity? But why should these banks be concerned about liquidity?

Commercial banks ought to be concerned about liquidity as it plays a crucial role in meeting their financial obligations. Also, liquidity is tied to the financial health of a bank. If a bank doesn’t have liquidity, it may find it hard to operate and serve its customers.

Liquidity is important for businesses and banks. More liquidity translates to good financial health, while zero liquidity translates to the opposite. Below, I have explained what liquidity is, why it is important, including why commercial banks should be concerned about having enough liquidity.

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Why Commercial Banks Should Be Concerned About Liquidity?

Liquidity is a common word used in the financial industry. If you don’t work in this industry or didn’t study a financial-related course, you may find it hard to understand liquidity. Of course, you may have an idea. But liquidity is more than having cash at hand. Let’s take a good look at what liquidity is before we consider the main purpose of this article.

What is Liquidity?

Liquidity has different definitions depending on the context, but it always has to do with one thing: cash or available money. Liquidity refers to the amount of money available to meet financial obligations like debt or investment. It indicates the levels of cash available and how fast a financial asset or security can be turned into cash without losing much value. In other words, how long it takes to sell.

Liquidity is significant because it indicates how flexible a company is in meeting its financial obligations and expected costs. It also applies to the typical individual. The more their liquid assets (Cash savings and investment portfolio), the better their financial status.

Up next, let’s look at why liquidity seems so important.

Why Is Liquidity Important?

The higher your liquidity, the better your financial health. The same applies to a business.

For instance, say, a company had a monthly loan payment of $6,000. Its sales are skyrocketing, and the company is making cool profits. It is on track to meet its $6,000 monthly obligation. Now, say a pandemic like the Coronavirus hit the economy. Demand for the business’s products plummeted so; therefore, it is not reeling in revenue and making profits; however, it still has to meet its $6,000 monthly loan bill. Unfortunately, the company only has about $2,000 of cash available and no liquid assets to sell for cash quickly. It will default on its loan within a month.

Now, if the company had, say, $15,000 in cash, including other liquid assets worth $30,000 that it could cash in on, it would be able to meet its debt obligations for many months to come until the economy gets better.

The same applies to people. The more savings a person has, the easier it is to settle their debts, like their car loan, credit card bills, mortgage, etc. This is very true if the person losses their job and immediate source of income. The more cash they have available and more liquid assets they can sell for cash, the easier it will be for them to continue paying their debt while searching for a new job.

We have looked at the general definition of liquidity. Next, let’s consider what we call bank liquidity. Understanding what bank liquidity is will help you understand if banks should be concerned about liquidity or not.

What is Bank Liquidly?

Liquidity means that a bank can meet its financial obligations. Put differently; if a bank can pay its debts and meet other financial obligations, it is liquid. As a result, the bank doesn’t need to be flush with cash. Instead, it may turn to credit lines to settle its obligations. It might also consider borrowing from another bank or business. Whatever the source, if the bank is liquid, it has access to cash at will.

Banks and the Problem of Liquidity:

Banks worldwide are facing issues with the liquidity crisis due to poor liquidity management. As every transaction or commitment affects a bank’s liquidity, managing liquidity risks is of great importance. Liquidity risk has become one of the most crucial elements in an enterprise-wide risk management framework.

A bank’s liquidity framework should maintain enough liquidity to resist all kinds of stress events that’ll be faced. Regular assessment of liquidity risk management framework, including liquidity positions, is a crucial supervisory action that’ll ensure the proper functioning of the bank. Many banks failed to consider several basic principles of liquidity risk management when liquidity was abundant.

Many banks didn’t have enough framework that satisfactory accounted for the liquidity risks posed by individual products and business lines. Thus incentives at the business level were rumpled with the total risk tolerance of the bank.

Having taken in enough information regarding bank liquidity, it is high time we revisited the crux of this article. Why should commercial banks be concerned about liquidity?

As said, liquidity is the ability to quickly turn an asset into cash without losing money against the market price. A commercial bank should be concerned about liquidity because settling their financial obligations becomes difficult or impossible without it. Enough liquidity translates to more cash at hand, giving a bank the ability to meet financial needs.

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Why Is Liquidity Such an Important Issue?

If you search for the word “liquidity” on Google, you get several articles on the topic, with some emphasizing the importance of liquidity. For those who have a good knowledge of liquidity, this wouldn’t come as a surprise for you. But for those who don’t, you might want to know why liquidity is such a big issue.

Liquidity is a big issue because it plays an important role in the ability of a company to settle its financial obligations, including payment of debt. Without liquidity, a company will find it hard to meet its obligations, resulting in several financial issues, especially in the case of debt.

If you decide to establish a business someday, ensure you prioritize liquidity as it is key to the smooth running of your business.

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