Liquidity management and reserves
There may be times when a large volume of cash is withdrawn by depositors and the bank has to be ready for that. Let us look at the (simplified) balance sheet for BarcSan as a whole, all its assets and all its liabilities.
We will assume that it keeps 8% of deposits as required reserves and aims to have a further 4% as excess reserves (either at the central bank or as vault cash). As well as £10 billion in deposits the bank has £900 million in capital accumulated mostly through retaining past profits. It has lent £5.7 billion and bought £3.1 billion of marketable securities such as government bonds and bills.BarcSan's balance sheet
| Assets | Liabilities |
| Required reserves £800m Excess reserves £1,300m Loans £5,700m Securities £3,100m | Deposits £10,000m Bank capital £900m |
To satisfy its own rule of 12% of current account deposits held as reserves it needs only £1.2 billion but it currently has £2.1 billion (£800m + £1,300m). It has a ‘spare' £900 million. If there is a sudden rise in withdrawals from bank accounts as people worry about the bank system collapsing and not being able to repay its deposit liabilities (as with Northern Rock in 2007, or Cypriot banks in 2013), this will have an impact on BarcSan. If £900 million of cash is withdrawn from BarcSan, its balance changes to:
BarcSan's balance sheet after a sudden withdrawal of £900 million
| Assets | Liabilities |
| Required reserves £728m Excess reserves £472m Loans £5,700m Securities £3,100m | Deposits £9,100m Bank capital £900m |
The bank still has cash reserves above its target because 12% of £9,100 million is £1,092 million (this apportioned as required reserves, 8% of £9,100m = £728m, and excess reserves, 4% of £9,100m = £364m), but the bank has £1,200 million (required reserves of £728 million plus excess reserves of £472 million).
Because it started with plentiful reserves the public panic to withdraw funds has not affected the other elements in BarcSan's balance sheet.Now take a different case, where BarcSan has already lent out any reserves above its prudential level of 12% of deposits.
BarcSan's balance sheet if actual reserves equal target reserves
| Assets | Liabilities |
| Required reserves £800m Excess reserves £400m Loans £6,600m Securities £3,100m | Deposits £10,000m Bank capital £900m |
Now imagine a financial panic: many depositors rush to the bank's branches to take out their money. In one day £900 million is withdrawn. At the end of the day the balance sheet is looking far from healthy.
BarcSan's balance sheet after £900 million is withdrawn (after the bank just met its reserve target)
| Assets | Liabilities |
| Required reserves £300m Excess reserves £0m Loans £6,600m Securities £3,100m | Deposits £9,100m Bank capital £900m |
Another day like that and it might be wiped out. It is required to hold 8% of £9,100 million as reserves, £728 million, but now has only £300 million. Where is it going to get the shortfall from? There are four possibilities.
1 Borrow from other banks and other organisations. The active markets in interbank loans, repos, commercial paper or certificates of deposit could be useful to raise the £428 million.
BarcSan's balance sheet if it borrows £428 million from the markets
| Assets | Liabilities |
| Required reserves £728m Excess reserves £0m Loans £6,600m Securities £3,100m | Deposits £9,100m Borrowed from banks and firms £428m Bank capital £900m |
However, given the cause of the crisis was a system-wide loss of confidence, BarcSan may have difficulty raising money in these markets at this time. This was a problem that beset many banks around the world in 2008, and then many eurozone banks in Greece, Cyprus, Portugal and Spain in 20112013.
They had grown used to quickly obtaining cash to cover shortfalls from other banks. But in the calamitous loss of confidence following the sub-prime debacle and the eurozone crisis, banks simply stopped lending - those that were caught with insufficient reserves failed or were bailed out by governments.2 Securities could be sold. Of the securities bought by a bank, most are traded in very active markets where it is possible to sell a large quantity without moving the price. Let us assume that the bank sells £428 million of government Treasury bills and bonds to move its reserves back to 8% of deposits.
BarcSan's balance sheet if it sells £428 million of securities
| Assets | Liabilities |
| Required reserves £728m Excess reserves £0m Loans £6,600m Securities £2,672m | Deposits £9,100m Bank capital £900m |
The short-term securities issued by respectable (safe) governments held by banks are classified as secondary reserves because they tend to be very easy to sell quickly, at low transaction cost and without moving the market price, even if sold in fairly high volume. Other securities held by the bank will have higher transaction costs of sale and are less easy to sell and so are not classed as secondary reserves.
3 Borrowing from the central bank. One of the major duties of a central bank is to act as lender of last resort. It stands ready to lend to banks that lack cash reserves. However, it will do this at a high price only (high interest rate) to deter banks from calling on it in trivial circumstances.[32] If BarcSan borrows the £428 million shortfall from the central bank to take it back to the regulator's minimum of 8%, its balance sheet now looks like this:
BarcSan's balance sheet if it borrows £428 million from the central bank
| Assets | Liabilities |
| Required reserves £728m Excess reserves £0m Loans £6,600m Securities £3,100m | Deposits £9,100m Borrowings from central bank £428m Bank capital £900m |
4 Reducing lending.
Banks receive principal repayments on loans every day as the periods of various loan agreements come to an end, or as portions of loans are repaid during the term of the loan. To raise some money the bank could simply refuse any more loans for a period. I was on the sharp end of this in February 2007 when trying to complete a business property deal. Suddenly Halifax Bank of Scotland refused to lend on what was a pretty safe deal for them. I was nonplussed. What were they playing at? Didn't they know they would lose my company as a customer? Of course, with hindsight we all know that this was the start of the crisis when HBOS was desperately short of cash (it avoided complete annihilation only by allowing itself to be bought by Lloyds). Another possibility is to sell off some of the loan book to another bank - but the purchasers are unlikely to pay full value, especially in uncertain times. An even more drastic solution is to insist that borrowers repay their loans immediately. This is possible with some types of loans such as overdrafts, but it results in much resentment and damage to long-term relationships. If BarcSan raised £428 million in one of these ways its balance sheet would look like this:BarcSan balance sheet after reducing loans by £428 million
| Assets | Liabilities |
| Required reserves £728m Excess reserves £0m Loans £6,172m Securities £3,100m | Deposits £9,100m Bank capital £900m |
Of course, there are a few more moves that need to be made if the bank wants to reach its target of 12% reserves, rather than simply get to 8%, but after such a crisis in the financial markets this may take a few years to achieve.
More on the topic Liquidity management and reserves:
- Liquidity management and reserves
- References
- The Supply of Money and Central Banks
- CONCLUSION
- 25 Monetary Policy and Fiscal Policy
- 12 Supply of Money
- Article 16.2 India cuts interest rate to revive growth
- English Monetary Theories and Debates in the Age of Classical Economics
- The Demand for Money
- INDEX