4 Liquidity – Background and Key Concepts

After having set out the main responsibilities of asset–liability management, the time has come to focus on the liquidity part of the mandate. In this chapter the concepts of liquidity and liquidity risk will be brought into the picture and an overview given of the various liquidity concepts. Rather than listing them one by one, it is more useful to introduce them in stages and through examples.

4.1 DEFINITIONS AND MORE DEFINITIONS

In order for something to be measured it first needs to be defined. Liquidity risk is not a new concept; a more fitting portrayal would be to call it an old one. As far back as the late 18th century economists understood the significance of the gap between the cash flows of assets and liabilities.1 One of the fundamental economic functions that banks provide is ‘maturity transformation’ by accepting short-term deposits and granting long-term loans. Maturity transformation is fundamentally a part of the liquidity concept, so it can be said that the notion of liquidity is as old as banking and embedded in their role.

As the oldest and most fundamental role of banks is to be an institution for maturity transformation one would expect a general acceptance and understanding of the function they provide. However, as we touched upon in Chapter 1, this seems from time to time to get forgotten and banks have been criticized and even stamped ‘reckless’ by borrowing short and lending long. As will be discussed in ...

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