Liquidity refers to the ease with which an asset can be converted into cash, and since cash is easily tradable, liquidity also refers to the ease with which cash can be traded. The business model of banks is such that they generally issue long-term assets and hold short-term liabilities. Banks therefore usually hold more short-term liabilities then short-term assets on their balance sheets while having more medium- to long-term assets then medium- to long- term liabilities. This is known as a maturity mismatch. During the normal course of business, liquidity will flow into a bank in the form of deposits and out of the bank when depositors withdraw their deposits. At the end of the day, one bank might have excess liquidity and another might have a shortage of liquidity. A bank with a shortage of liquidity needs to borrow to make sure it has enough liquidity so that it can meet its short-term obligations. Conversely, a bank with a liquidity surplus has more liquidity than it needs, so it would prefer for those extra funds to be earning interest rather than sitting idle. The interbank market fulfils the needs of both surplus units and deficit units in the banking sector. Money market instruments are considered to be highly liquid since they have a maturity of less than one year, and because they are easily tradable, their marketability makes them cash equivalents.
59 | P a g e Most banks borrow and lend money in the interbank market for a period of less than a week and most of those are overnight-only transactions. The local interbank market is a source of short-term finance for banks, and for longer-term finance banks could look overseas.
Unlike in other industries, where the bankruptcy of a competitor may be welcome news, in the banking industry, a bank failure sets off tremors in the industry because banks are heavily connected. The primary reasons for the failure of one bank being disruptive to the whole financial system is twofold. The first has to do with the public’s perception of the strength of the banking sector because a run on a healthy bank could shut it down on account of the asset maturity mismatch . The second relates to with counterparty risk. Unlike during the banking crisis that led to the Great Depression, a run on a bank is highly unlikely to mean queues of depositors lining up to withdraw their deposits in the US. This is because most deposits are federally insured and banks can use the interbank market to obtain liquidity (not relying solely on depositors). South African banks do not have deposit insurance. However, in its financial system stability assessment of South Africa, the IMF recommended that South African introduce a deposit insurance scheme (DIS) to reduce systemic liquidity risk (International Monetary Fund, 2014). Counterparty risk stems from the interconnectedness of financial institutions. When two parties enter into a contract, each party is exposed to the risk that its counterparty will not live up to the contractual obligations. When counterparty risk increases, banks’ incentive to trade with one another diminishes. Even when the interbank interest rate increases in order to offset the increase in counterparty risk, it does not guarantee that surplus units will lend to deficit units because those banks that are most desperate for liquidity will pay the higher rate, while safer borrowers are less desperate for liquidity and could look elsewhere for funding. Hence during times of high uncertainty, safe borrowers might be pushed out of the market by high interest rates, leaving only unsafe borrowers in the
60 | P a g e market. This serves as an incentive for surplus units to hang on to their additional liquidity and in an extreme situation the whole interbank market could seize up if surplus units are completely unwilling to lend to deficit units (The Economist, 2007).
If banks are unable to meet their liquidity requirements by borrowing, they are forced to sell assets. When many institutions are suffering from liquidity shortages due to a macroeconomic event, such as large-scale defaults on loans, there will be fewer investors willing to buy assets. The high supply of assets and low demand result in a fall in the prices of these assets. If investors are uncertain about the fundamental value of these assets, this could force banks to sell assets at prices below the expected present value of the payments on the asset, which is known as “fire sale prices” (Blanchard, 2009). As banks sell more assets, the price drops and the value of similar assets on their balance sheet or on the balance sheets of other banks will fall when using mark-to-market accounting. This cycle continues as the value of assets held by banks decreases, and they might have to sell assets or reduce their lending to maintain their capital ratios, further feeding into the fall in asset prices. Selling assets to maintain liquidity and capital ratios amplifies initial losses due to the macroeconomic event, but in the case of the financial crisis, these two amplification mechanisms were extremely strong because of the opacity of complicated financial assets (Blanchard, 2009). The true value of these complicated assets created doubt about the solvency of banks and further discouraged private lending.