Taking the risk out of banking: Liquidity requirements versus equity requirements

Richmond Federal Reserve writes:  The financial crisis of 2007 – 08 revealed the dangers of banks’ underinvestment in liquid assets or overreliance on high-risk funding sources. At some level, however, liquidity risk is part of a core function performed by banks: maturity transformation. In traditional banking, this means accepting deposits and making loans.

This leads to “maturity mismatch” between banks’ liabilities and assets – many of a bank’s liabilities are short-term and payable on demand to depositors and other creditors, while many of its assets are long-term and illiquid. A bank without enough liquid assets to meet a sudden increase in demand on its liability side may be forced to sell assets quickly at reduced prices or suspend operations. And since some banks act as sources of funding for other banks or financial firms, strain at one institution could cause broader disruptions to the financial system.

While large nonbank financial institutions rely on funding sources other than deposits, the maturity mismatch principle is still the same. Shortterm funding sources, such as commercial paper and repurchase agreement (repos), are rolled over very frequently – sometimes even daily. But if creditors suspect weakness on the part of the bank or the securities underlying a repo, they may choose not to roll over the debt in favor of extending that credit to another institution. This sudden loss of funding could create a scenario similar to a classic bank run.  Report