Why is Liquidity Important in Banking? Which Pillar of Basel-III Discusses Liquidity Risk?
Liquidity is very important in banking because it ensures that a bank can meet its financial obligations and cash withdrawal demands on time. A bank must maintain sufficient liquid assets to handle unexpected cash outflows and stressed financial situations.
In 2008, many banks faced severe problems due to poor liquidity risk management. Therefore, maintaining adequate liquidity is essential for the stability and survival of banks.
Importance of liquidity in banking:
1. Liquidity helps a bank to meet deposit withdrawals and payment obligations.
2. It protects banks during financial stress and crisis situations.
3. Liquidity ensures smooth banking operations by funding day-to-day activities.
4. Liquidity enhances confidence among depositors and investors. As a result, the bank’s goodwill increases in the market. The banks get more customers and deposits. The foundation of the bank gets stronger.
5. Liquidity supports overall financial stability.
It should be noted that the bank shouldn’t keep excess liquidity. Excess liquidity is costly since idle cash itself doesn’t generate profit. So, banks should practice strong liquidity management and keep only a calculated amount of liquidity to safeguard their business.
Pillar of Basel-III
Liquidity risk management is primarily discussed under Pillar-1 of the Basel-III framework. Liquidity risk is mainly addressed through the introduction of two liquidity standards:
Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio (NSFR)
