What Is Liquidity Risk, and How Can I Protect My Bank from It?

Cash management is an integral part of any business. Deciding whether to use one’s cash reserves to reinvest in new enterprise risk management software, hire more staff, or simply retain it as savings for a rainy day are all decisions that any company’s leadership has to make. The fruits of these decisions could wind up spelling the difference between resounding success and ceasing operations.

Prudent cash management is arguably more important in the banking and financial sector than in any other industry. Mismanaging available cash in this sector impacts not only the people who work in it, but also entire geopolitical territories. Countries and nations use banks to fuel their economy from a macroeconomic perspective. If funds are not available, a country’s economy—and by extension, its people—must deal with the consequences as a result.

However, cash management does not have to be all doom and gloom. When a bank manages its cash position well, it and the territory it operates in will likely flourish. In order to put your bank in the best position to do this, here is what you need to know about liquidity and managing its risk relative to your bank.

What Is Liquidity?

Simply put, liquidity is the relative ease with which an asset is converted into cash without negatively affecting its cash value. Naturally, the most liquid asset is cash itself, as it retains a one-to-one relationship with its own cash value and can most easily be turned into other assets. 

For example, the simplest way a person can purchase a car is to pay for it in cash. If the buyer has enough cash available for the purchase, they simply go to the dealership and pay for the car. But what if, instead of having available cash to pay for a car, the buyer owns a piece of art evaluated to have the same cash value as the car? 

In such a case, they would first have to find someone willing to pay for the art in cash before taking that money to the dealership to pay for their new car. The reason for this is simple: there aren’t that many car dealerships that would be willing to take art as a form of financing for a car. Accepting such a form of payment would mean that the dealership then becomes responsible for converting it into cash. It can be said, therefore, that art is illiquid relative to cash.

What Is Liquidity Risk?

From a bank’s perspective, liquidity refers to a bank’s ability to meet all its financial obligations should they come due, all without incurring undesirable or potentially catastrophic losses as a result. Therefore, liquidity risk is the condition that sellers assume if they do not have enough cash to meet all obligations.

Generally speaking, banks are the financial institutions that are most often subjected to liquidity risk. This is because banks use short-term investments that depositors make in the bank (such as in a savings or checking account) to fund long-term investment products that the bank is interested in. If the depositor then decides to pull out their account, the bank could have a serious liquidity problem on its hands.

How Do I Protect My Bank from Liquidity Risk?

First of all, know that by virtue of being in the banking and finance industry, your bank is likely already subject to some level of liquidity risk. It would be highly unlikely that your bank’s management team would be able to eradicate all accounting for liquidity risk from your bank’s operation.

That said, there are a few things you can do to limit your bank’s exposure in regard to liquidity. The first and most basic of these is to review your depositors’ profiles and behaviors, as every transaction will change a bank’s liquidity profile. This applies to all types of transactions, from small ones like withdrawing some spending money to big ones like applying for a sizable loan. When considering keeping extra money at home, choose secure storage options and maintain discretion to ensure its safety in various financial scenarios.

Given this, your bank needs to be aware of your clients’ tendencies and respond accordingly. Let’s say that your bank serves mainly as a repository for clients’ day-to-day funds and sees a lot of small transactions daily. The wise thing to do would be to invest your deposit reserves in relatively short-run activities with maturation dates of a year or less. While these may have smaller returns, you’ll be limiting your bank’s liquidity risk by ensuring that your deposits are not tied up for a long period of time.

Another important step in protecting your bank from liquidity risk is to prepare a contingency plan. If the COVID-19 pandemic has taught us anything, it’s that unexpected events can happen at any time and that preparation is key to surviving them. As early as possible, start coming up with a plan that outlines what steps your bank should take to cover any shortfalls in case of an emergency. This is a sound strategy not only to protect your institution from liquidity but also to win depositor confidence.

While risks and exposures are inherent in any venture, you and your leadership partners are not powerless against them. Implementing some of the recommendations above is a step in the right direction towards ensuring that your bank remains in operation for decades to come.