“Banking Liquidity” is a bank’s ability to meet their financial obligations when they are due, without sustaining unacceptable losses.

A balance between assets and liabilities needs to maintained. A bank’s primary assets are its loans, which need to be repaid to the bank, and its reserves. The main liability is their customer’s cash deposits, as these need to be paid out on demand. Banks are able to increase their liquidity by attracting new capital via enhanced deposit rates and promotions, borrowing from wholesale markets or from the Bank of England, to name a few.

Increasing their capital reserves by borrowing from other institutions increases the pressure on the bank’s margins. This is then passed on to the banks customers by decreasing the rates that the bank pays to depositors, or by increasing the rates that it charges on the loans. This in turn can affect the bank’s ability to attract new deposits and sell more loans, a vicious circle!

The financial strength of a bank, as determined by credit agencies, also affects its ability to borrow capital and at what cost, or even to be able to borrow capital at all. We have seen in the last few days a downgrade of the UK’s biggest banks amid growing fears of a meltdown in the Eurozone.  This means that these banks could pay billions of pounds extra to raise funds, which could increase rates on loans and mortgages for households and businesses.

Rules here in the UK, via the Bank of England’s Financial Policy Committee (FPC) and global rules set by the Basel III agreement on bank capital adequacy, stress testing and market liquidity risk; means that banks need to retain certain levels of capital reserves against losses in order to prevent another financial crisis.

The end result is that banks are not lending sufficient capital into the market place to householders or businesses; they are further tightening up their lending criteria so fewer applications are successful, or the terms available are not cost effective or suitable to the borrower.

You might argue that in the past the banks have lent money far too easily or cheaply and this created the financial crisis that we still see ourselves in.  However, in order for the UK to have a full economic recovery we need to see banks helping householders and businesses with available credit at reasonable costs.

On June 14, the Bank of England announced that together with the UK government, they would provide billions of pounds of cheap credit to banks, on the basis that they increase lending to companies and individuals.

Previous attempts to get banks lending have failed as banks have retained the cheap capital raised to satisfy the regulators liquidity rules.  The banks now need to release this capital into the wider economy and by doing so it will allow for goods and services to be funded, credit facilities to be provided or extended, jobs to be created and ultimately it will help our economy to grow. Whether this will happen in reality is yet to be seen, but if it doesn’t, I don’t know how many other tricks the Bank of England has up its sleeve to get things moving again.

Article written by Geoff Morrey-Jones July 2012