|Part of a series on financial services|
Fractional-reserve banking is the most common form of banking practised by commercial banks worldwide.It involves banks accepting deposits from customers and making loans to borrowers, while holding in reserve a fraction of the bank's deposit liabilities. Bank reserves are held as cash in the bank or as balances in the bank's account at the central bank. The minimum amount that banks are required to hold in liquid assets is determined by the country's central bank, and is called the reserve requirement or reserve ratio, but each bank can hold more than this minimum amount that takes into account their particular situation and liability profile.
A bank is a financial institution that accepts deposits from the public and creates credit. Lending activities can be performed either directly or indirectly through capital markets. Due to their importance in the financial stability of a country, banks are highly regulated in most countries. Most nations have institutionalized a system known as fractional reserve banking under which banks hold liquid assets equal to only a portion of their current liabilities. In addition to other regulations intended to ensure liquidity, banks are generally subject to minimum capital requirements based on an international set of capital standards, known as the Basel Accords.
Bank reserves are a commercial bank's cash holdings, that are physically held by the bank, and deposits held in the bank's account with the central bank. Under the fractional-reserve banking system used in most countries, central banks typically set minimum reserve requirements that require commercial banks under its purview to hold cash or deposits at the central bank equivalent to at least a prescribed percentage of their liabilities, such as customer deposits. Such sums are usually termed required reserves, and any funds above the required amount are called excess reserves. These reserves are prescribed to ensure that, in the normal events, there is sufficient liquidity in the banking system to provide funds to bank customers wishing to withdraw cash. Even when there are no reserve requirements, banks often as a matter of prudent management hold reserves in case of unexpected events, such as unusually large net withdrawals by customers or bank runs. In general, banks do not earn any interest on its reserves. Funds in banks that are not retained as a reserve are available to be lent, at interest.
A fraction represents a part of a whole or, more generally, any number of equal parts. When spoken in everyday English, a fraction describes how many parts of a certain size there are, for example, one-half, eight-fifths, three-quarters. A common, vulgar, or simple fraction consists of an integer numerator displayed above a line, and a non-zero integer denominator, displayed below that line. Numerators and denominators are also used in fractions that are not common, including compound fractions, complex fractions, and mixed numerals.
Bank deposits are often of a relatively short-term duration while loans made banks tend to be longer-term, and banks working on the expectation and experience that only a proportion of depositors will seek to withdraw funds at the one time, keep only a fraction of their liabilities as reserves. However, banks can still experience an unexpected bank run, when more depositors wish to withdraw more funds than the reserves held by the bank. In that event, the bank experiencing the shortfall may borrow from other banks in the interbank lending market; or if there is a general lack of liquidity among the banks, the country's central bank may act as lender of last resort to provide banks with funds to cover this short-term shortfall.
A bank run occurs when many clients withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system, numerous customers withdraw cash from deposit accounts with a financial institution at the same time because they believe that the financial institution is, or might become, insolvent; they keep the cash or transfer it into other assets, such as government bonds, precious metals or gemstones. When they transfer funds to another institution, it may be characterized as a capital flight. As a bank run progresses, it generates its own momentum: as more people withdraw cash, the likelihood of default increases, triggering further withdrawals. This can destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy. To combat a bank run, a bank may limit how much cash each customer may withdraw, suspend withdrawals altogether, or promptly acquire more cash from other banks or from the central bank, besides other measures.
The interbank lending market is a market in which banks extend loans to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate. A sharp decline in transaction volume in this market was a major contributing factor to the collapse of several financial institutions during the financial crisis of 2007–2008.
A lender of last resort (LOLR) is the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market and other facilities or sources have been exhausted. It is, in effect, a government guarantee of liquidity to financial institutions. Since the beginning of the 20th century, most central banks have been providers of lender of last resort facilities, and their functions usually also include ensuring liquidity in the financial market in general. The objective is to prevent economic disruption as a result of financial panics and bank runs spreading from one bank to the next from a lack of liquidity in one. Different definitions of the lender of last resort exist in literature. A comprehensive one is that it is "the discretionary provision of liquidity to a financial institution by the central bank in reaction to an adverse shock which causes an abnormal increase in demand for liquidity which cannot be met from an alternative source".
Because banks hold reserves in amounts that are less than the amounts of their deposit liabilities, and because the deposit liabilities are considered money in their own right, fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank.In most countries, the central bank (or other monetary policy authority) regulates bank credit creation, imposing reserve requirements and capital adequacy ratios. This helps ensure that banks are solvent and have enough funds to meet demand for withdrawals, and can be used to limit the process of money creation in the banking system. However, rather than directly controlling the money supply, central banks usually pursue an interest rate target to adjust the rate of inflation and bank issuance of credit.
The money supply is the total value of money available in an economy at a point of time. There are several ways to define "money", but standard measures usually include currency in circulation and demand deposits. Each country’s central bank may use its own definitions of what constitutes money for its purposes.
A central bank, reserve bank, or monetary authority is an institution that manages the currency, money supply, and interest rates of a state or formal monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monetary base in the state, and also generally controls the printing/coining of the national currency, which serves as the state's legal tender. A central bank also acts as a lender of last resort to the banking sector during times of financial crisis. Most central banks also have supervisory and regulatory powers to ensure the solvency of member institutions, to prevent bank runs, and to discourage reckless or fraudulent behavior by member banks.
Monetary policy is the policy adopted by the monetary authority of a country that controls either the interest rate payable on very short-term borrowing or the money supply, often targeting inflation or the interest rate to ensure price stability and general trust in the currency.
Fractional-reserve banking predates the existence of governmental monetary authorities and originated many centuries ago in bankers' realization that generally not all depositors demand payment at the same time. [ page needed ]
In the past, savers looking to keep their coins and valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit (see Bank of Amsterdam ). These notes gained acceptance as a medium of exchange for commercial transactions and thus became an early form of circulating paper money.As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.
Gold is a chemical element with the symbol Au and atomic number 79, making it one of the higher atomic number elements that occur naturally. In its purest form, it is a bright, slightly reddish yellow, dense, soft, malleable, and ductile metal. Chemically, gold is a transition metal and a group 11 element. It is one of the least reactive chemical elements and is solid under standard conditions. Gold often occurs in free elemental (native) form, as nuggets or grains, in rocks, in veins, and in alluvial deposits. It occurs in a solid solution series with the native element silver and also naturally alloyed with copper and palladium. Less commonly, it occurs in minerals as gold compounds, often with tellurium.
Silver is a chemical element with the symbol Ag and atomic number 47. A soft, white, lustrous transition metal, it exhibits the highest electrical conductivity, thermal conductivity, and reflectivity of any metal. The metal is found in the Earth's crust in the pure, free elemental form, as an alloy with gold and other metals, and in minerals such as argentite and chlorargyrite. Most silver is produced as a byproduct of copper, gold, lead, and zinc refining.
A goldsmith is a metalworker who specializes in working with gold and other precious metals. Historically, goldsmiths also have made silverware, platters, goblets, decorative and serviceable utensils, ceremonial or religious items, and rarely using Kintsugi, but the rising prices of precious metals have curtailed the making of such items to a large degree.
If creditors (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, however, many would try to redeem their notes at the same time. If, in response, a bank could not raise enough funds by calling in loans or selling bills, the bank would either go into insolvency or default on its notes. Such a situation is called a bank run and caused the demise of many early banks.
A creditor is a party that has a claim on the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption that the second party will return an equivalent property and service. The second party is frequently called a debtor or borrower. The first party is called the creditor, which is the lender of property, service, or money.
Insolvency is the state of being unable to pay the money owed, by a person or company, on time; those in a state of insolvency are said to be insolvent. There are two forms: cash-flow insolvency and balance-sheet insolvency.
These early financial crises led to the creation of central banks. The Swedish Riksbank was the world's first central bank, created in 1668. Many nations followed suit in the late 1600s to establish central banks which were given the legal power to set the reserve requirement, and to specify the form in which such assets (called the monetary base) are required to be held.In order to mitigate the impact of bank failures and financial crises. central banks were also granted the authority to centralize banks' storage of precious metal reserves, thereby facilitating transfer of gold in the event of bank runs, to regulate commercial banks, impose reserve requirements, and to act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs which is inherent in fractional-reserve banking, and it allowed the practice to continue as it does today.
During the twentieth century, the role of the central bank grew to include influencing or managing various macroeconomic policy variables, including measures of inflation, unemployment, and the international balance of payments. In the course of enacting such policy, central banks have from time to time attempted to manage interest rates, reserve requirements, and various measures of the money supply and monetary base.
In most legal systems, a bank deposit is not a bailment. In other words, the funds deposited are no longer the property of the customer. The funds become the property of the bank, and the customer in turn receives an asset called a deposit account (a checking or savings account). That deposit account is a liability on the balance sheet of the bank. Each bank is legally authorized to issue credit up to a specified multiple of its reserves, so reserves available to satisfy payment of deposit liabilities are less than the total amount which the bank is obligated to pay in satisfaction of demand deposits.
Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors' cash withdrawals and other demands for funds. However, during a bank run or a generalized financial crisis, demands for withdrawal can exceed the bank's funding buffer, and the bank will be forced to raise additional reserves to avoid defaulting on its obligations. A bank can raise funds from additional borrowings (e.g., by borrowing in the interbank lending market or from the central bank), by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining reserves. Thus the fear of a bank run can actually precipitate the crisis.
Many of the practices of contemporary bank regulation and central banking, including centralized clearing of payments, central bank lending to member banks, regulatory auditing, and government-administered deposit insurance, are designed to prevent the occurrence of such bank runs.
Fractional-reserve banking allows banks to provide credit, which represent immediate liquidity to depositors. The banks also provide longer-term loans to borrowers, and act as financial intermediaries for those funds.Less liquid forms of deposit (such as time deposits) or riskier classes of financial assets (such as equities or long-term bonds) may lock up a depositor's wealth for a period of time, making it unavailable for use on demand. This "borrowing short, lending long," or maturity transformation function of fractional-reserve banking is a role that many economists consider to be an important function of the commercial banking system.
The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals. Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy.
Additionally, according to macroeconomic theory, a well-regulated fractional-reserve bank system also benefits the economy by providing regulators with powerful tools for influencing the money supply and interest rates. Many economists believe that these should be adjusted by the government to promote macroeconomic stability.
When a loan is made by the commercial bank, the bank is keeping only a fraction of central bank money as reserves and the money supply expands by the size of the loan.This process is called "deposit multiplication".
The proceeds of most bank loans are not in the form of currency. Banks typically make loans by accepting promissory notes in exchange for credits they make to the borrowers' deposit accounts.Deposits created in this way are sometimes called derivative deposits and are part of the process of creation of money by commercial banks. Issuing loan proceeds in the form of paper currency and current coins is considered to be a weakness in internal control.
The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold – usually a small amount). Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States.
There are two types of money created in a fractional-reserve banking system operating with a central bank:
When a deposit of central bank money is made at a commercial bank, the central bank money is removed from circulation and added to the commercial banks' reserves (it is no longer counted as part of M1 money supply). Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits.
The money multiplier is a heuristic used to demonstrate the maximum amount of broad money that could be created by commercial banks for a given fixed amount of base money and reserve ratio. This theoretical maximum is never reached, because some eligible reserves are held as cash outside of banks.Rather than holding the quantity of base money fixed, central banks have recently pursued an interest rate target to control bank issuance of credit indirectly so the ceiling implied by the money multiplier does not impose a limit on money creation in practice.
The money multiplier, m, is the inverse of the reserve requirement, R:
In countries where fractional-reserve banking is prevalent, commercial bank money usually forms the majority of the money supply.The acceptance and value of commercial bank money is based on the fact that it can be exchanged freely at a commercial bank for central bank money.
The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process.Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled.
Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have been created throughout the world to address these problems.
Government controls and bank regulations related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:
The currently prevailing view of reserve requirements is that they are intended to prevent banks from:
In some jurisdictions, (such as the United States and the European Union), the central bank does not require reserves to be held during the day. Reserve requirements are intended to ensure that the banks have sufficient supplies of highly liquid assets, so that the system operates in an orderly fashion and maintains public confidence.
In addition to reserve requirements, there are other required financial ratios that affect the amount of loans that a bank can fund. The capital requirement ratio is perhaps the most important of these other required ratios. When there are no mandatory reserve requirements, which are considered by some economists to restrict lending, the capital requirement ratio acts to prevent an infinite amount of bank lending.[ citation needed ]
To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with, notably, regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance:
Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:
As with reserves, other sources of liquidity are managed with targets.
The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, causing a bank run to occur.[ citation needed ]
Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2–3 months' etc. These residual contractual maturities may be adjusted to account for expected counter party behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.[ citation needed ]
An example of fractional-reserve banking, and the calculation of the "reserve ratio" is shown in the balance sheet below:
|Example 2: ANZ National Bank Limited Balance Sheet as of 30 September 2037|
|Balance with Central Bank||2,809||Term deposits and other borrowings||35,231|
|Other liquid assets||1,797||Due to other financial institutions||3,170|
|Due from other financial institutions||3,563||Derivative financial instruments||4,924|
|Trading securities||1,887||Payables and other liabilities||1,351|
|Derivative financial instruments||4,771||Provisions||165|
|Available for sale assets||48||Bonds and notes||14,607|
|Net loans and advances||87,878||Related party funding||2,775|
|Shares in controlled entities||206||[subordinated] Loan capital||2,062|
|Current tax assets||112||Total Liabilities||99,084|
|Other assets||1,045||Share capital||5,943|
|Deferred tax assets||11||[revaluation] Reserves||83|
|Premises and equipment||232||Retained profits||2,667|
|Goodwill and other intangibles||3,297||Total Equity||8,703|
|Total Assets||107,787||Total Liabilities plus Net Worth||107,787|
In this example the cash reserves held by the bank is NZ$3,010m (NZ$201m Cash + NZ$2,809m Balance at Central Bank) and the Demand Deposits (liabilities) of the bank are NZ$25,482m, for a cash reserve ratio of 11.81%.
The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc.
For example, the ANZ National Bank Limited balance sheet above gives the following financial ratios:
It is important how the term 'reserves' is defined for calculating the reserve ratio, as different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.
Glenn Stevens, governor of the Reserve Bank of Australia, said of the "money multiplier", "most practitioners find it to be a pretty unsatisfactory description of how the monetary and credit system actually works."
Lord Adair Turner, formerly the UK's chief financial regulator, said "Banks do not, as too many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo – extending a loan to the borrower and simultaneously crediting the borrower’s money account".
Former Deputy Governor of the Bank of Canada William White said "Some decades ago, the academic literature would have emphasised the importance of the reserves supplied by the central bank to the banking system, and the implications (via the money multiplier) for the growth of money and credit. Today, it is more broadly understood that no industrial country conducts policy in this way under normal circumstances."
In 1935, economist Irving Fisher proposed a system of 100% reserve banking as a means of reversing the deflation of the Great Depression. He wrote: "100 per cent banking ... would give the Federal Reserve absolute control over the money supply. Recall that under the present fractional-reserve system of depository institutions, the money supply is determined in the short run by such non-policy variables as the currency/deposit ratio of the public and the excess reserve ratio of depository institutions." [ page needed ]
Today, monetary reformers point out that fractional reserve banking leads to unpayable debt, growing inequality, inevitable bankruptcies, and an imperative for perpetual and unsustainable economic growth.
Austrian School economists such as Jesús Huerta de Soto and Murray Rothbard have also strongly criticized fractional-reserve banking, calling for it to be outlawed and criminalized. According to them, not only does money creation cause macroeconomic instability (based on the Austrian Business Cycle Theory), but it is a form of embezzlement or financial fraud, legalized only due to the influence of powerful rich bankers on corrupt governments around the world.US Politician Ron Paul has also criticized fractional reserve banking based on Austrian School arguments.
Monetary policy concerns the actions of a central bank or other regulatory authorities that determine the size and rate of growth of the money supply. For example, in the United States, the Federal Reserve is in charge of monetary policy, and implements it primarily by performing operations that influence short-term interest rates.
Money market is an important part of the economy which provides short-term fund.The money market is the part of financial market which deals in the borrowing and lending of short-term loans generally for a period of less than or equal to 365 days.
The Reserve Bank of India (RBI) is India's central banking institution, which controls the issuance and supply of the Indian rupee. Until the Monetary Policy Committee was established in 2016, it also controlled monetary policy in India. It commenced its operations on 1 April 1935 in accordance with the Reserve Bank of India Act, 1934. The original share capital was divided into shares of 100 each fully paid, which were initially owned entirely by private shareholders. Following India's independence on 15 August 1947, the RBI was nationalised on 1 January 1949.
Monetary reform is any movement or theory that proposes a system of supplying money and financing the economy that is different from the current system.
Full-reserve banking is a proposed alternative to fractional-reserve banking in which banks would be required to keep the full amount of each depositor's funds in cash, ready for immediate withdrawal on demand. Funds deposited by customers in demand deposit accounts would not be loaned out by the bank because it would be legally required to retain the full deposit to satisfy potential demand for payments. Proposals for such systems generally do not place such restrictions on deposits that are not payable on demand, for example time deposits.
An open market operation (OMO) is an activity by a central bank to give liquidity in its currency to a bank or a group of banks. The central bank can either buy or sell government bonds in the open market or, in what is now mostly the preferred solution, enter into a repo or secured lending transaction with a commercial bank: the central bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as collateral. A central bank uses OMO as the primary means of implementing monetary policy. The usual aim of open market operations is—aside from supplying commercial banks with liquidity and sometimes taking surplus liquidity from commercial banks—to manipulate the short-term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply, in effect expanding money or contracting the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.
The reserve requirement is a central bank regulation employed by most, but not all, of the world's central banks, that sets the minimum amount of reserves that must be held by a commercial bank. The minimum reserve is generally determined by the central bank to be no less than a specified percentage of the amount of deposit liabilities the commercial bank owes to its customers. The commercial bank's reserves normally consist of cash owned by the bank and stored physically in the bank vault, plus the amount of the commercial bank's balance in that bank's account with the central bank.
In monetary economics, a money multiplier is one of various closely related ratios of commercial BANK money to central bank money under a fractional-reserve banking system. It measures the maximum amount of commercial bank money that can be created, given a certain amount of central bank money and ignoring leakages into currency held by the non-bank public. That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend when there are no leakages is equal to a multiple of the amount of reserves. This multiple is the reciprocal of the reserve ratio, and it is an economic multiplier. The actual ratio of money to central bank money, also called the money multiplier, is lower because some funds are held by the non-bank public as currency and most banks hold excess reserves
Money creation is the process by which the money supply of a country, or of an economic or monetary region, is increased. In most modern economies, most of the money supply is in the form of bank deposits. Central banks monitor the amount of money in the economy by measuring the so-called monetary aggregates.
Asset and liability management is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.
In financial economics, a liquidity crisis refers to an acute shortage of liquidity. Liquidity may refer to market liquidity, funding liquidity, or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.
Pushing on a string is a figure of speech for influence that is more effective in moving things in one direction than another – you can pull, but not push.
A deposit account is a savings account, current account or any other type of bank account that allows money to be deposited and withdrawn by the account holder. These transactions are recorded on the bank's books, and the resulting balance is recorded as a liability for the bank and represents the amount owed by the bank to the customer. Some banks may charge a fee for this service, while others may pay the customer interest on the funds deposited.
Monetary policy is the process by which the monetary authority of a country, generally the central bank, controls the supply of money in the economy by its control over interest rates in order to maintain price stability and achieve high economic growth. In India, the central monetary authority is the Reserve Bank of India (RBI). It is designed to maintain the price stability in the economy. Other objectives of the monetary policy of India, as stated by RBI, are:
Liquidity regulations are financial regulations designed to ensure that financial institutions have the necessary assets on hand in order to prevent liquidity disruptions due to changing market conditions. This is often related to reserve requirement and capital requirement but focuses on the specific liquidity risk of assets that are held.
Banks are dangerous institutions. They borrow short and lend long. They create liabilities which promise to be liquid and hold few liquid assets themselves. That though is hugely valuable for the rest of the economy. Household savings can be channelled to finance illiquid investment projects while providing access to liquidity for those savers who may need it.... If a large number of depositors want liquidity at the same time, banks are forced into early liquidation of assets – lowering their value ...'