A closer look at liquidity risk
A bank keeps a proportion of the money it raises in the form of cash (and near cash) rather than lending it all to lower liquidity risk, running out of liquid assets. Let us assume for now that a bank, BarcSan, is required by the central bank (its regulator) to hold 8% of the value of its deposits in reserves.
These are the regulatory required reserves. However, the bank may judge that 8% is not enough and decide to add another 4% of the value of its current account liabilities as excess reserves. Reserves consist of both the cash that the bank is required to hold in its account with the central bank and cash that it has on its own premises, referred to as vault cash. Note that we are referring here to cash reserves and not the capital reserves (the difference between assets and liabilities). Cash reserves are there to avoid running out of cash, a short-term phenomenon, whereas capital reserves are there to avoid running out of net assets (assets minus liabilities).Cash reserves of 12% are unusually high, but useful for illustration. A more normal figure is 1-3% of overall liabilities (not just deposit liabilities) held in cash, but another 10% or so might be held in assets that can quickly be converted to cash, such as very short-term loans to other banks, certificates of deposit for money placed with other banks in tradable form and government Treasury bills - these are termed near cash. The term for reserves that includes near cash is liquid reserves.
To understand the working of a bank we will start with a very simple example of a change in the cash held by a bank. Imagine that Mrs Rich deposits £1,000 of cash into her current account at the BarcSan Bank. This has affected the bank's balance sheet. It has an increase of cash, and therefore reserves, of £1,000. This is an asset of the bank. At the same time it has increased its liabilities because the bank owes Mrs Rich £1,000, which she can withdraw any time.
We can illustrate the changes by looking at that part of the balance sheet that deals with this transaction. In the T-account below, the asset (cash) is shown on the left and the increased liability is shown on the right.BarcSan partial balance sheet
| Assets | Liabilities |
| Vault cash (part of reserves) £1,000 | Current account £1,000 |
This increase in reserves could also have come about through Mrs Rich paying in a £1,000 cheque drawn on an account at, say, HSBC. When BarcSan receives the cheque it deposits it at the central bank, which then collects £1,000 from HSBC's account with the central bank and transfers it to BarcSan's account at the central bank, increasing its reserves. Remember: cash reserves include both those held at the central bank and those in the bank vault, tills, ATMs, etc.
Given that BarcSan has required reserves at 8% of current account deposits, following the receipt of £1,000 it has increased assets of £80 in required reserves and £920 in excess reserves.
BarcSan partial balance sheet
| Assets | Liabilities |
| Required reserves £80 Excess reserves £920 | Current account £1,000 |
These reserves are not paying a high interest to BarcSan.[31] What is even more troubling is that the bank is providing an expensive service to Mrs Rich with bank branch convenience, cheque books, statements, etc. This money has to be put to use - at least as much of it as is prudent. One way of making a profit is to lend most of the money. It does this by lending to a business for five years. Thus the bank borrows on a short-term basis (instant access for Mrs Rich) and lends long (five-year term loan). The bank decides to lend £880 because this would allow it to maintain its required reserve ratio of 8% and its target excess reserve of 4%.
BarcSan partial balance sheet
| Assets | Liabilities |
| Required reserves £80 Excess reserves £40 Loan £880 | Current account £1,000 |