The Principles of Banking, 2nd Edition

CHAPTER 11Principles of Bank Liquidity Management

Abstract

Running and managing liquidity risk is the identifying feature of a banking institution. The act of undertaking the basic business of banking, that of cash maturity transformation, generates liquidity risk. Banks must manage this risk effectively to ensure that they remain liquid at all times and under all circumstances. The fundamental principles of bank liquidity management remain unchanged over many years, and require only refresher courses to remain current. At the same time, changes in market conditions, market infrastructure and banking regulation introduce additional challenges and requirements. We present core principles of bank liquidity management as well as good-practice processes in this chapter.

The bank crash of 2007 and 2008 was for some of the banks that failed as much a crisis of liquidity as it was of capital erosion, and the events of that period restated the importance of efficient liquidity management in banking. Compared to the aftermath of previous instances of bank failures, however, regulatory authorities took their cue from the Basel Committee and implemented much more onerous supervision requirements pertaining to liquidity risk management, such that banks today are compelled to hold a much larger share of their balance sheet in the form of low credit risk, genuinely liquid assets. In the post-Basel III era, liquidity risk management in banks is as much about demonstrating regulatory compliance ...