Bank Liquidity and Capital

Banks have a conflict between profitability and liquidity.

Liquidity is important as it protects a bank against bad debt, debt which has been defaulted.
Debt is promised to the bank, so it counts as an asset, but the asset can lose all its value if the borrower defaults.

However, banks want to be profitable, so they can grow, pay their employees more and increase market share. In order to be profitable, you have to make investments / loans, which are risky. These are harder to convert back to cash when needed, so the bank becomes less liquid as all their assets are harder to convert to cash.

Banks need to strike a balance between liquidity, so they don't go bankrupt, while being as profitable as possible.

Secured vs Unsecured Loans

Secured loans are loans where the bank can take an asset if the borrower defaults. These have much lower interest rates because the bank has to take much less risk, and so they don't have to charge higher interest rates to compensate for borrowers defaulting.

Secured loans are less risky.

Liquidity Ratios

A liquidity ratio is the ratio of liquid assets held by a bank to their overall assets. Banks need to hold enough to cover expected demands from consumers withdrawing deposits.

• After the 2008 Financial Crisis, the Basel Agreement was introduced which required Commercial Banks to keep enough liquid assets such as cash and government bonds to get through a 30-day market crisis
• May refer to a reserve assets ratio for a bank which a bank must maintain to prepare for a sudden increase in withdrawals
• A high liquidity ratio may limit the amount of lending that a business is able to do because it must maintain more cash

Capital Ratios

Measures funds against riskier assets that could be vulnerable in a crisis.

A healthy ratio is 1:1

The EU runs stress tests to check if banks have enough capital buffer to weather difficult economic scenarios.