How Banks Deal with Liquidity Problems - Literature review Example

Macro & Micro economics s Submitted by s: How banks deal with liquidity problems Liquidity is the capa to fund increases in assets and at the same time meet the obligations when they are due, and remains critical to the continuing viability of banking firms (Koch and MacDonald, 2010, p. 447). Hence, the management of liquidity can be considered among the most critical activities that banks conduct as when done appropriately, it reduces the probability of serious problems. The degree of sophistication and formality that is employed in managing liquidity is subject to the magnitude and complexity of the bank, along with the characteristics and convolution of its operations. The management of liquity is an on-going process that obligates bankers to track and forecast the flow of cash in to make sure that liquidity is maintained adequately and thus preserving a balance between long-term liabilities and short-term assets is important. In the case of individual banks, the deposits made by the customers are their main source of liabilities, while the loans and reserves are its main assets since they are owned to the bank. The key source of liquidity is the investment portfolio, representing a smaller portion of assets, while investment securities may be liquidated in order to satisfy withdrawal of deposits and increased demands for loans (Greuning, Brajovic Bratanovic and Greuning, 2003, p. 221). Banks can also employ other options for the generation of liquidity including borrowing from other banks, selling loans, raising additional capital as well as borrowing from central banks like the US Federal Reserve. In more severe cases, depositor demand for their funds at a time when the bank is not able to raise enough cash without incurring significant amounts of losses financially. Such cases may lead to bank runs where the banks are subject to legitimately mandated requirements that intend to assist them to avoid liquity crises. Banks are usually able to maintain adequate liquity since the government insures bank deposits in some of the developed countries. Inadequate liquidity can be mitigated through increasing deposit rates as wells as successfully marketing deposit products. Nonetheless, a vital aspect of the success and value of a bank is the cost associated with liquidity since banks can attract considerable liquid funds. Relatively lower costs result in more profits, increased stability and a rise in confidence for the depositors, regulators as well as investors. In the cases where the bank is not able to meet liquidity requirements, it may be forced to borrow in the interbank market in order to deal with the shortfalls (Ellinger, Lomnicka and Hare, 2011, p. 754). Conversely, some banks face issues of excess liquid assets that surpass liquidity requirements and thus have to lend money to other banks in the interbank markets, and in the process, they receive interests on the assets. An interbank rate is the interest rate that is charged on the short-term loans that banks lend to each other, where the rate of interest charged is subject to the availability of funds in the market, the particular terms of the contract like the length of the loan, as well as prevailing rates. Various banks allow this borrowing and lending as a means of managing liquidity and satisfying regulations and there are several published interbank rates such as the LIBOR, federal banks rate and Eurozone. How banks deal with capital inadequacy There are instances when banks are faced with cases of inadequate capital and are forced to seek measures and strategies that will mitigate this issue (Scott, 2005, p. 300). One of the approaches that can be taken by banks to deal with this, targets the retained earnings of the bank through seeking to decrease the share of its profits paid out in terms of dividends. On the other hand, the bank may decide to boost profits by itself and the most obvious way to do this is through increasing the gaps between the interest rates it is paying for its funding and the rates it is charging for loans. Even though competitive pressure may restrict the degree to which a bank is able to broaden this spread, lending spreads can increase in the entire system when all banks follow the same strategy while alternate channels of funding do not provide rates that are more attractive. Other means of increasing net income entail increase in profit margins on other lines of business including reduction of the costs of operation and advisory or custody services. Another approach entails issuing new equity, for instance through a rights issue to the already existing shareholders, placing a fraction of shares with external investors or offering equity on the open markets. However, this is typically the least favourable option since issuance of new share is supposed to decrease the value of the shares already existing in the market. Other adjustment strategies entail making changes to the assets side of the balance sheet of the bank through running down loan portfolios or selling assets and utilize the proceeds from the sale of assets and loan repayments as a means of paying down the debt (Singh, 2012, p. 206). Alternatively, banks can slow down their lending growth, as this will allow retained earnings and capital to catch up. In other cases, selling assets can increase the retained capitals by means of accounting gain since the value of the assets is reconsidered subject to the cost of purchase. The choice of the bank from among these measures will be a determinant of the macroeconomic effect of a rise in regulatory capital ratios. For instance, if the banks want to slow their lending or decrease their lending to risky projects, this can have a constraining effect on investment and even consumption. Therefore, evidence that a decline in the growth of bank lending originates from reduced supplies of bank loans and not reduced demand for the loans from the borrowers would become evident through more stringent bank lending standards. Broadening bank-lending spreads may also lead to a decline in investments on the margin, particularly if it feeds lending rates that are available through lenders outside the market or in capital markets (Shekhar and Shekhar, 2006, p. 60). Conversely, if the banks issue new shares or decrease their dividends payouts, it may result in a decrease in returns received by the shareholders while having negligible effect on the wider macro-economy. It is imperative to not that in the end, neither a slowdown in the increase in bank lending nor a decrease in outstanding bank loans would be have negative macroeconomic effects in the long term. Traditional banking versus modern banking Banks are financial intermediaries and money creators that create money through lending money to borrowers and thus creating resultant deposits on the balance sheets of the bank. These lending activities occur directly, either through giving loans, or indirectly, through the capital markets. As a consequence of their significance in the financial system as well as effect on various economies, numerous nations have enacted significant laws with the aim of ensuring the industry remains highly regulated (Chiline, 2002, p. 12). Since inception, banks have played a vital part through performing important services to the functioning of economies like protection, lending, transfer and exchange of money in different forms as well as the evaluation of creditworthiness of customers. Money is a means of exchange and the foundation of the contemporary economy, and banks are significantly involved in the distribution of money in the whole society. Even though numerous institutions are currently involved in the distribution of money, banks continue to be essential to the flow of money to maintain various levels of the economy. Banks have been traditionally playing this important role through performing important services that are critical to the functioning of economies. The protecting peoples holdings can be considered as the oldest function of banks and even before the existence of banks, people sought ways of securing their valuables. For instance, in some societies such as Babylonia, people stored their money in temples as they considered that there was less likelihood of people stealing from the houses of their gods. Ancient records show that temples lent and exchanged money and in the process acted like banks. The protection of money does not merely entail physical protection and this makes record keeping another critical aspect of securing money and traditional banking. Traditionally, banks have devoted a lot of time and attention to practices and technologies of maintaining and storage of precise records. Since banks allow their customers to hold and use their money, they have to track it carefully, and the same code is applied to large transactions that occur between banks and governments as well as banks and various industries. Traditional banking has also been involved in identification as a security aspect of banking as only the authorized individuals are allowed to access various accounts. Nonetheless, the identification aspect does not deal with local bank branches alone, this is because identity theft is an increasing concern and banks are working together with various experts as well as law enforcement personnel to put a stop to various kinds of identity theft. Money is also traditionally safeguarded through enforcement, which entails catching anyone who attempts to take it through physical security and pursuance of legal actions on the people who make the banks incur losses. Traditional forms of banking also engage in sound business practices in order to protect money through processes that require good judgment of day-to-day banking activities. The banks invest money and time in the training of employees so that they can be conversant with the necessary practices and procedures with the training objectives being accuracy, good decision-making and making good financial decisions. This ensures that the critical role played by banks in the economy is effective. Even though there are different ways of moving money in economies, banks critical to the establishment of the financial environment to allow transfer of money that leads to stabilization and growth of monetary supplies. Additionally, traditional banks lend money to customers so that they can purchase what they normally would not be able to buy and in the process determines the creditworthiness so that they avoid losing their money through bad loans (Chiline, 2002, p. 101). Banking has developed into an exciting and fast moving activity that is accessible all over the globe, with changes in technology, regulation and competition pushing banks to become dynamic firms, which should react quickly to the evolving circumstance of businesses. Among the most considerable changes in forms of banking in the last few decades have been the mergers that have taken place. Mergers take place when more than one bank come together or acquire other banks in order to increase the size of the banks and thus provide more resources. On the other hand, since mergers bring together more than one bank, it decreases the number of banks in the industry. Banking has become an international business as a result of advances in technology that has enabled instant communication and funds transfers that have circumvented geographical barriers. Numerous commercial banks are actively seeking global business, taking part in investment banking and drawing huge transactions abroad. In the same way as various other industries, technology has been the source of change in the banking industry, as no other industry has been influenced by the development of telecommunications and computers than banking. This has led to evaluation, auditing and accounting functions being taken over by faster and effective technologies, while transfer of funds, financial analysis and record keeping are immediate as a result of the powerful instruments that are available. Advancements in technology have not been restricted to the banks only as the relationship between consumers and their banks have also undergone some changes. the traditional 9 to 3 banking hours no longer apply as consumers seek more immediate access to services in the same manner they conduct the rest of their businesses (Ellinger, Lomnicka and Hare, 2011, p. 215). The customers want to access their money at any time and this has necessitated technological innovations like ATMs, smart cards with microchips and networks as well as online banking through the internet that have brought changes to the banking experience. Competition is a continuing challenge in the banking industry since it is a business and all businesses experience competition. The banking industry has experienced loosening off government regulations and this has resulted in competition becoming stiffer and fiercer. This situation has led to mergers, which have consequently decreased the number of banks while at the same time increasing the number of services that can be accessed by customers in the process of competing to earn the financial businesses of the customers. The competition that banks face comes from other banks as well as the firms, which sell financial services, like credit unions. Banks are now increasingly sales-oriented and emphasize more in services, marketing as well as innovation, which are aspects that were rare in the past several decades. Impact financial innovation on consumer borrowing Financial innovation is the process of creating and popularizing newer financial tools along with financial institutions, technology and markets in regards to processes and products (Ferran, 2012, p. 127). Innovations in regards to products is associated with new products like mortgages, derivatives and securitized assets while process innovations entail newer approaches of doing business such as telephone banking, online banking and better ways if innovation implementation in the financial industry. On the other hand, institutional innovations are involved in creating newer forms of financial companies. Some forms of financial innovation are influenced by enhancements in telecommunication and computer technology and most people consider things like ATMs as being better financial innovations compared to asset backed securitization. Other forms of financial innovation that have an effect on payment systems are debit and credit cards, along with online payment systems such as PayPal. These forms of innovation are prominent since the decrease the costs of transactions. Since households seek to maintain lower cash balances, when the economy demonstrates cash-in-advance constraints, then these forms of financial innovation may lead to more efficiency. These innovations can also have an effect on monetary policies through reduction of household balances, and with the rise in acceptance of online banking, people can be able to retain bigger fractions of their wealth in non-cash tools. Various scholars are confident in the capacity of central banks to maintain the goals of their policies through affecting the short-term interest rates as e-money has significantly decreased the demand for liabilities associated with the central banks. It is usually thought that innovations in the financial markets, especially in regards to mortgages for homes and consumer credit, played a significant part in the Great Moderation, assisting in the reduction of severity of business cycles in the twenty years prior to the financial crisis (Xiao, 2008, p. 112). However, evidence of the advantages of financial innovation from the entire community is exceptionally weak and this casts a lot of doubt on the theory that financial innovation has been integral to the Great Moderation. This has considerable ramifications for discussions concerning new laws on financial regulation but should not be neglected as it has some benefits. Scholars have stated that even though financial innovation may not have significant benefits, it is important to identify the benefits and their importance. Through the financial crisis, it has become clear that changes, which occurred in the financial system, including liberalization, deregulation, rise in activities and introduction of newer and complicated securities, played a part in causing the crisis and could not have prevented the contemporary economy from experiencing disasters. Nonetheless, the manifestation of the crisis does not certainly mean that financial innovation was not beneficial; particularly, liberalization and deregulation may have been beneficial in reducing the effects on the economy by the small and moderate shocks. For instance, financial innovation could have created a situation where risks were more widely spread throughout the economy. Prior to the crisis, numerous policy makers and scholars held the view that financial innovation had benefits, with some claiming that a lot of measures had been instigated to liberalize and deregulate the financial sector. The need for these changes are evident and a liberal or market oriented financial sector nurtures effective allocation of scarce resources and thus creates a more prosperous economy. Additionally, the financial sector has experienced rapid advancement in technology innovations, aiding an increase in new products and an increasing sophistication in the manner in which financial institutions deal with risks. These perceptions might be correct in terms of the economy benefiting from liberalization and deregulation provided the shocks are not very unusual. It can be concluded that the decrease in house prices was rather unusual since it was experienced in numerous regions and nations at the same time. These perceptions may also be true since economies can benefit provided they safeguard themselves in a better manner against risks including lack of transparency and high advantage linked to proliferation of newer securities. Various studies have revealed that financial innovation played a part in the Great Moderation which was a sustained period characterized by moderate business cycles. This theory is strengthened by the practical fact that co-movement of actual activities with consumer loans along with organizational loans had vanished in the Great Moderation, even though they had been previously high. Theories that state that financial innovation reduces business cycles forecast this kind of decrease in co-movement, where the idea is that reductions in the supply of loans worsen recessions in the rigid financial markets (Knoop, 2010, p. 249). On the other hand, consumers and organizations that need funds will have an ability to borrow when the financial markets are efficient and this will increase the likelihood of weathering the storm. The responses that followed monetary policy shocks changed considerably, but not in a manner that was consistent with the opinion that financial innovation reduced the effect. is Evidence has suggested that decreases in consumer mortgages after monetary tightening became bigger with the reductions being as a result of sharp reduction of bank holdings of consumer mortgages, even though other financial institutions increased their mortgages at this time. Bibliography Chiline, V. 2002, Modern trends in global banking development, Dissertation, com, USA. Ellinger, E., Lomnicka, E. and Hare, C. 2011, Ellingers modern banking law, Oxford University Press, Oxford. Ellinger, E., Lomnicka, E. and Hare, C. 2011, Ellingers modern banking law, Oxford University Press, Oxford. Ferran, E. 2012, The regulatory aftermath of the global financial crisis, Cambridge University Press, Cambridge. 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