Banks despite giving the belief they have plenty of money can at times face a liquidity risk because they fall short of funds either to pay depositors back or to advance fresh loans. A liquidity risk is therefore defined as the inability of the bank to conduct its day-to-day operations.

Banks are required to make provisions for adequate liquidity in their premises because it is crucial for their operations. Any shortfall in the liquidity will mean that the bank will be unable to meet its commitments to other banks or financial institutions which can leave behind serious repercussions on the reputation of the bank as well as the prices of the bonds issued by the bank to the money market.

A liquidity crisis can on occasions lead to what is commonly known as a “bank run” when depositors make a beeline for the bank to withdraw their money and such occasions can easily aggravate the situation. It is for this reason that full-service banks such as J.P. Morgan, Morgan Stanley, and all other banks are required proactively to maintain their liquidity risk in order to remain in a healthy condition.

Banks have the option of turning to the Fed in situations where the liquidity is facing dire situations. It is well known that financial institutions borrowed heavily from the Fed during the subprime crisis which engulfed the market in 2008-2009.

[su_quote cite=”Ben Bernanke” class=”cust-pagination”]As you know, in the latter part of 2008 and early 2009, the Federal Reserve took extraordinary steps to provide liquidity and support credit market functioning, including the establishment of a number of emergency lending facilities and the creation or extension of currency swap agreements with 14 central banks around the world. [/su_quote]

A Liquidity Crisis Can Ruin Banks

A liquidity crisis has the potential to ruin banks as it has been observed in various instances during the past. In recent times Northern Rock a small bank from northern England and Ireland had to be taken into state ownership because of its inability to manage liquidity risk. The bank did not have a large depositor base and was using just a small part of its deposits to advance fresh loans.

The bank was making use of short-term loans which were available to fund the fresh loans it was giving out. It was depending on the easy availability of credit from the financial markets to fund the loans they were giving out. During the difficult times of 2007-2008, the bank was unable to sell the loans it had advanced like it had been doing earlier. At the same time, it was unable to secure short-term credit.

The difficulties for the bank began to aggravate when depositors started to withdraw their money because of the financial crisis leading to a severe liquidity problem. The bank managed to get a credit line from the government but was unable to do anything against the problems which persisted. Ultimately the government had to take over the bank.

A Liquidity Crisis Can Hit Any Bank Which Is Not Careful

It is essential for every bank to maintain adequate levels of liquidity failing which the bank would have to deal with the crisis mentioned within this discussion. Banks are required to make adequate provisions for the money they advance as loans along with the deposits they receive. Banks also have the option of borrowing short-term loans from other financial institutions to cover any shortfall they may be facing. However, at no time can bank afford to overlook their depositor base and advance loans far in excess of the deposits they have.

Short term loans that are borrowed by banks must be returned within the time specified because financial institutions would have made it incumbent upon the bank to do so. It is precisely for this reason that all banks are required to leave a certain sum of money to the feds to cover for a liquidity crisis which could have arisen because of bad management or a financial crisis that had not been anticipated.