Features & Sacco Leadership

Liquidity risk and banks

Liquidity risk and banks: How does liquidity risk relate to market risk and credit risk? What is the best way to measure liquidity risk?

Liquidity risk is a significant concern for banks, arising naturally from their daily operations. At its core, this risk stems from the way banks manage their finances—particularly the common practice of funding long-term loans, like mortgages, with short-term liabilities, such as customer deposits.

This creates a “maturity mismatch,” where the timing of cash inflows and outflows doesn’t align perfectly. If many depositors suddenly decide to withdraw their money, the bank could face serious liquidity issues.

The challenge of liquidity risk is further intensified by banks’ reliance on unstable sources of funding, like wholesale funding, which can disappear quickly in times of financial stress. When combined with the possibility of sudden and unexpected withdrawals, this makes liquidity management a critical function for banks.

To address these risks, banks must follow strict regulations designed to ensure their stability. One of the key regulatory frameworks guiding banks is Basel III, an international standard developed by the Basel Committee on Banking Supervision.

Basel III sets out stringent requirements to help banks manage liquidity risk and withstand financial shocks. This framework is applied to major banks in regions like the European Union, the United States, the United Kingdom, Japan, Canada, and Australia.

In the U.S., for instance, Basel III rules are enforced for large bank holding companies with assets exceeding $250 billion, with some requirements also impacting smaller regional banks. The framework includes important measures like the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).

  • Liquidity Coverage Ratio (LCR): Banks are required to hold enough high-quality liquid assets that can be quickly converted to cash. This ensures they can meet their cash outflows for 30 days under a stress-test scenario.
  • Net Stable Funding Ratio (NSFR): This measure requires banks to maintain a stable funding structure relative to the nature of their assets and off-balance sheet activities, promoting long-term resilience.

 

Andrew Walyaula
Author: Andrew Walyaula

Andrew Walyaula is a seasoned multimedia journalist. waliaulaandrew0@gmail.com

Andrew Walyaula

About Author

Andrew Walyaula is a seasoned multimedia journalist. waliaulaandrew0@gmail.com

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