What is Bank Liquidity and Why is it Important?

The global financial crisis of 2007 – 2009 is a classic example of what happens when banks do not have enough cash to pay their debts, e.g., all those items on the liability side of their balance sheets. The reasons for the named financial crisis have been written about and discussed and dissected many times, which is why banks and other financial institutions have to adhere to very strict rules implement by their own authorities, on the back of the Basel iii Agreement*.

*The Basel iii Agreement was implemented in 2009 after the global financial meltdown, this agreement was produced by the Bank for International Settlements in conjunction with 28 central banks from across the globe. This agreement was designed to promote stability in the international banking sector and is a set of reforms to mitigate risk that require banks to keep certain levels of liquidity and maintain certain leverage ratios.

Simply put, banks are now required to maintain adequate cash or assets that can be easily turned into cash to meet the demands of depositors and financial market counterparty transactions in the event of an economic shock as seen in the global financial crisis and in events in March 2023. If liquidity rules are revoked in any way the results can be catastrophic as in the failures of Silicon Valley Bank and Signature Bank in March 2023, which also resulted in a run on other banks.

These failures were put down to President Donald Trump signing into law a bill that reduced scrutiny on banks with assets under USD250 Billion. This was down to the naive thought that with the extra liquidity now available to certain banks, they would be able to invest the funds profitably. What became clear, however, is that these financial rules make a huge difference, and are truly there to stop banks failing. 

Sadly, it appears that despite financial disasters, lessons are never learned and the next financial crisis could be just around the corner. If this is the case, it is hoped that throughout the major financial centres in the world, the banks have got their houses in order. Indeed, last year the vice president of the European Central Bank announced that banks in Europe had robust liquidity and high capital ratios and depositors would be safe in times of economic stress. Furthermore, recent announcements from the Federal Reserve in the United States advise they will stress test thirty two large lenders in scenarios under severe economic shock.

Today it appears that financial authorities and regulators have put in place (or are putting in place) sufficient regulations and stress tests that will satisfy the Basel iii agreement. However, extreme vigilance must be constant by authorities and political masters should be advised to keep well away from the rules and regulations of banking systems. Financial shocks always come as a surprise, so it is always important to make sure that the regulations implemented to protect society are followed to a letter, and not just undone the moment someone forgets about the last crisis.