What Is Core Liquidity?
Core liquidity refers to the cash and other financial assets that banks possess that can easily be liquidated and paid out as part of operational cash flows (OCF). Examples of core liquidity assets would be cash, government (Treasury) bonds, and money market funds.
- Core liquidity is the total of cash and other immediately marketable assets that a bank has on hand to fund its liquidity needs.
- Banks use core liquidity to balance the liquidity risk of failing to pay its obligations against the opportunity cost of holding cash.
- Overestimating core liquidity needs leads to missing out on some revenue from lending, but underestimating core liquidity needs can lead to failure of the bank.
Understanding Core Liquidity
The core liquidity of a bank are those assets (cash, cash equivalents, Treasuries, etc.) that can be used immediately for the bank's liquidity needs to meet its payment obligations. On the other hand, banks create liquidity for others through lending and finance activities. By creating liquidity in the market, the banking industry earns profits and serves an important role in the economy, but in turn must tie up some of its funds in less liquid assets.
Banks thus face two central issues with respect to managing their liquidity position. The main management position of banks is to balance liquidity creation with liquidity risk. Liquidity risk for a bank includes both the risk of being unable to fund its financing commitments (such as lending activities or paying interest to its own lenders) and the risk of being unable to meet the demand for withdrawals (the extreme case being a run on the bank). A shortage of liquidity at a bank can end up leading to the failure and closure of the bank; liquidity shortages across a particularly large bank or many banks at once can precipitate a financial crisis.
A potential shortage of liquidity is considered to be one of the most prominent risks facing banks, and at the same time a liquidity surplus is considered a drag on competitiveness because those funds are unable to be lent to new borrowers and thus earn interest income. Banks typically use forecasts to anticipate the amount of cash that account holders will need to withdraw, but it is important that banks do not overestimate the amount of cash and cash equivalents required for core liquidity because unused cash left in core liquidity cannot be used by the bank to earn increased returns. This presents an opportunity cost for the bank.
According to economists Chagwiza, Garira, and Moyo (2015), banks ought to construct a "core liquidity portfolio" to optimize the liquidity buffer to minimize these risks that banks face—rather than simply holding an arbitrary reserve of cash. This way, the balance between liquidity risk and opportunity cost is maximized for banks, and their efficiency and overall profitability is increased.
Example of Core Liquidity
Of course, predicting future cash needs is a tricky business and will rarely be spot on. For example, assume that XYZ bank is able to charge 15% interest on the loans it extends. In the event that the bank overestimates the amount of core liquidity needed by $100,000, the bank will miss out on $15,000 ($100K x 0.15) worth of interest income because it has $100,000 in cash tied up that cannot be used for lending. On the other hand, if XYZ bank underestimates its core-liquidity needs by $100,000, it may need to receive emergency support from a central bank, seek a bailout from another bank, or face the risk of a run on its assets and accounts.