Banking 4

What is bank liquidity?

Access to cash and other sources of funds to meet day-to-day expenses and commitments.

What is liquidity risk?

Risk that a bank cannot meet its obligations or turn assets into cash quickly without significant loss.

Why is bank liquidity important?

Lack of liquidity can lead to insolvency, especially during a crisis or a bank run.

What are Exchange Settlement Accounts (ESAs)?

Accounts held by banks at the RBA to settle interbank payments in Australia.

What is Real-Time Gross Settlement (RTGS)?

A system where payments are settled individually in real-time, reducing systemic risk.

What is Deferred Net Settlement (DNS)?

A system where payments are aggregated and settled at the end of the day, increasing settlement risk.

What are the three sources of bank liquidity?

Scheduled liquidity, asset liquidity (stored), and liability liquidity (purchased).

What is asset liquidity?

Selling liquid assets such as cash, ES funds, or government securities to meet liquidity needs.

What is liability liquidity?

Borrowing from interbank markets, issuing securities, or accessing central bank funding.

What is the Liquidity Coverage Ratio (LCR)?

Stock of high-quality liquid assets divided by total net cash outflows over 30 days, must be ≥100%.

What is the Net Stable Funding Ratio (NSFR)?

Available stable funding divided by required stable funding over a 1-year period, must be ≥100%.

What is a liquidity index?

A measure of potential loss from selling assets quickly, calculated by comparing sale prices to fair value.

What is the liquidity risk-return trade-off?

More liquidity reduces risk but lowers returns; less liquidity raises returns but increases risk.

How do banks determine optimal liquidity?

By forecasting liquidity needs, setting a buffer, and balancing cost with risk.

What causes bank runs?

Loss of depositor confidence, solvency fears, or contagion from other failing banks.

What regulatory mechanisms address bank runs?

Deposit insurance and central bank discount windows like repos and rediscount facilities.

A bank with a large DNS exposure and minimal ESA buffer faces a sudden default by another bank. What risk is it facing, and why?

Settlement risk and systemic risk. DNS delays settlement, and without ESA liquidity, the bank may be unable to meet its obligations, causing contagion.

Why would a bank choose liability liquidity over asset liquidity during seasonal liquidity shortages?

Because the timing is predictable, allowing structured borrowing with scheduled repayments. It avoids selling low-yield liquid assets unnecessarily.

If a bank has strong capital but poor liquidity, which funding strategy should it use and why?

Asset liquidity. The bank’s capital base can absorb temporary losses, and selling assets avoids increased leverage or added interest costs from borrowing.

A bank consistently maintains excess LCR and NSFR. What’s the hidden cost?

Over-liquidity results in holding low-yield assets, reducing profitability and return on equity—dampening shareholder value.

In what scenario might asset liquidity worsen a bank’s capital position?

If selling assets requires fire-sale pricing, capital may erode due to realized losses—reducing equity and regulatory capital ratios.

How can a high NSFR be misleading?

It might suggest long-term funding stability, but if funding sources are expensive or illiquid themselves, it masks deeper funding cost risks.

A bank’s liquidity index drops from 0.92 to 0.65 in one quarter. What does this indicate?

The bank’s asset portfolio has become less liquid or more risky—potential losses from rapid sales have increased significantly.

Why might a bank with perfect RTGS functionality still face liquidity stress?

RTGS processes payments in real time, but requires high intra-day liquidity. If a bank lacks ES funds, it may fail to settle payments on time.

What’s the link between bank runs and the demand deposit contract?

It operates on a “first come, first served” basis—early withdrawers get paid first, creating panic and incentivizing mass withdrawals.

What would you advise a small regional bank with a weak market presence to prioritize—asset or liability liquidity? Why?

Asset liquidity. Smaller banks struggle to raise funds in markets due to lower credit ratings and visibility, making stored liquidity safer.

How might Basel III liquidity ratios impact credit growth in the banking sector?

By requiring more stable, low-risk funding and liquid asset holdings, banks may reduce riskier lending to preserve compliance, limiting credit growth.

A sudden shift in investor sentiment increases demand for non-bank financial assets. What’s the liquidity impact on banks?

Deposit drains rise, forcing banks to raise funds or sell assets, increasing funding costs and liquidity stress—especially under tight LCR constraints.