What Is Liquidity?

Liquidity is a bank’s ability to generate cash quickly and at a reasonable cost. Thus, liquidity risk is the risk that a bank will not be able to generate enough cash to meet its short-term needs without incurring large costs.

Banks need liquidity in order to meet routine expenses, depositor demands and normal loan growth. Liquidity is also needed to meet unforeseen liquidity shocks, such as deposit runoffs, and to accommodate sudden changes in loan demand. Liquidity allows a bank to do all this without making costly balance sheet adjustments.

The most extreme example of a liquidity shock is a bank run. If all depositors attempted to withdraw their money at once, almost any bank would be unable to cover its claims and would fail, even though it might otherwise be in sound financial condition. Accordingly, a bank must carefully project and plan for its liquidity needs, or it may be forced to turn to high-cost sources of funding to cover liquidity shocks, thus cutting into profitability.

This section reviews bank liquidity. It discusses bank liquidity sources, describes monitoring and planning for bank liquidity needs, and discusses ways to analyze a bank’s liquidity position.

Lesson Objectives

This section provides you with a summary of liquidity. When you finish this section of the course, you should be able to:

  1. define liquidity,
  2. recognize factors that affect liquidity and
  3. identify components of liquidity and investment policies.