1.Explain the importance of liquidity for commercial banks and identify the main sources of liquidity in a typical commercial bank’s balance sheet. 3

2.Outline the reasons why, as a matter of monetary policy, central banks control liquidity in the banking system. 4

3.Describe briefly the method(s) used by central banks to control liquidity in the banking system. 5

References 6

Explain the importance of liquidity for commercial banks and identify the main sources of liquidity in a typical commercial bank’s balance sheet.

Banks are considered to be as safe deposit for customers associated with them for both short and long term basis. It has increased liability over banks to make sure that they are able to fulfill all the demands of the customers. Also the Federal Deposit Insurance Corporation Improvement Act has reduced the dependency that commercial banks used to possess over Federal Reserves to make sure that their needs are sufficed in case some emergency arrives. Thus to maintain certain level of stake in the company, it is mandatory for commercial banks to retain appropriate liquidity ratios such that any ambiguous situation could be avoided. If any disturbance is encountered in these ratios, there is a problem of funding that comes into picture and hampers bank’s credibility among its stakeholders. Liquidity control is also necessary for proper structuring of the bank along with looking after all the complexities related to the size and related measures. Thus commercial banks adopt controlling measures for liquidity risk in a highly comprehensive fashion. (Liquidity)

Some of the sources of liquidity associated with commercial banks are,

Deposits in other banks on demand basis

Marketable debt securities over a qualitative basis

Commitment made with other banks over provision of credit

As liquidity is a critical issue for commercial banks, thus in most of the cases they tend to follow a reliable source of liquidity that will help in retaining their ratios to the required limit and make sure that low cost sources of liquidity are always a part of the bank’s functioning. Also to maintain proper liquidity ratios bank take several actions like selling redeemable assets, restriction of new loans, fund borrowing, issue of capital instruments, and reduction in dividends. These measures help in maintain ratios to exist above a particular level that indicate that bank responds in those conditions when its reserve ratio targets are disturbed. These ratios are derived from the regulations and liabilities that are associated with the bank’s functioning and put a number of obligations that has to be carried out under any circumstances.

Outline the reasons why, as a matter of monetary policy, central banks control liquidity in the banking system.

Central Bank is the key authority that can be held responsible for carrying out the regulatory activities. It is central bank that control credit growth and liquidity in the banking system with the help of a number of tools to make sure that a firm monetary policy is formulated and followed in the entire banking system. It takes care of the management that is involved in regulating supply of money in the entire banking system thus its regulations also helps banks in maintaining their ratios above required limit such that their reserves does not fall beyond a certain frontier.

Financial sector is one of those sectors that have to be supervised by some certain entity otherwise it will result into an unregulated segment heading in an uncontrolled manner. Central Banks perform has not only taken, but also performed this duty in a highly beneficial manner for entire financial sector. Gravity of the situation can be understood from the fact that pace of a nation’s economy is regulated by the supply of money it is having, which in turn depends over central bank’s decisions. Thus central banks make an indirect contribution in the economic growth of the company through banking system that operates entirely under its control. There may be conditions when banks have high cash available with them, but injecting them without any condition in the market will not provide required return, rather it should be handled with optimum care to channelize their available resources and make sure that both banking system and markets get benefit of that availability of cash. Finally it will also help in boosting up of economy. (Central bank vows to damp excess liquidity, credit growth )

Describe briefly the method(s) used by central banks to control liquidity in the banking system.

Central bank is concerned authority that puts a check over liquidity factor existing in banking sector, it follow some of the guidelines to make sure that it does not gets deviated from its track. In order to do so some of the methods followed are,

It sets the bank reserve ratio that every bank has to retain with itself so as to take care of its customers at any time on their demand. Limit of this ratio may be increased or decreased based over the demand possessed by the external conditions. These conditions are reliant over highly volatile financial market thus has to be altered on a regular basis by the central bank otherwise it may result into fatality of many reputed financial institutions that will ultimately hamper functioning of national economy. (Zhiming, 2007)

It also has to perform an action of liquidity management that is related to the economic adjustments which can be performed with the help of amendments in the policies that are formulated on an initial basis and applied afterwards. Applications of these policies are based over expansion of domestic consumption that finally aims at retention of economic stability. For this purpose, central bank also has to take numerous other factors into consideration that are even slightly related to the economic modifications.

As economic growth is depicted by actions and regulations applied by central bank, thus it is up to central bank that whether it follow a discreet monetary policy or make some changes in its multiple monetary policy tools in order to attain a pre defined economic growth that will ultimately help in stabilizing economic health of the banking system.