Introduction.
Financial institutions (FI) face a systemic liquidity risk. The nature of the risk is that any FI holds relatively illiquid assets that have to be used to cover unexpected withdrawal claims. Liquidity risk can be managed by balancing the liquid assets and liabilities. Two other motivating factors to manage financial institution’s assets are governmental monetary policy and taxation issues.
Liquid Asset Management.
A liquid asset can be turned into cash quickly and with a minimal transaction cost. The ultimate liquid asset is cash. Liquidity risk is mitigated by holding large quantities of liquid assets. However, such method results in losses for FIs since liquid assets bear little to no interest.
In order to insure the stability of the system, the government regulates the minimum amount of liquid assets that a FI must hold at all times.
Monetary Policy Implementation Reasons.
Governments regulate liquidity of institutions by establishing a minimum ratio of liquid reserves to deposits. In addition to liquidity protection, such measure regulates the money supply to the economy. Decrease in the ratio results in influx of money to the economy, a decrease – limits such supply. Forcing FIs to hold assets in government claims is an additional “tax” on FIs.
The Composition of the Liquid Asset Portfolio.
Some countries require a specific combination of cash and government securities to be held as mandatory reserve for FIs. For deposit institutions (DIs) only cash reserve is accepted.
Return-Risk Trade-off For Liquid Assets.
Optimization of liquid assets by an FI is greatly influenced by minimum holding requirements. To follow the government rules, an FI can hold more liquid assets than is optimal and thus looses on interest profits.
