Because a number of countries have reformed or removed their requirements, the paper also examines transition issues in such changes. This paper reviews key analytical issues and central bank practices pertaining to liquid asset requirements, focusing on their effectiveness as a monetary or prudential tool. In the area of banking, this effort involved implementing structural reforms in banking, including banking supervision and bank restructuring, to enhance banks’ efficiency in liquidity management and steps to enhance the effective implementation and transmission of monetary policy, including through streamlining the payment and settlement system. In the area of public debt management, it involved greater emphasis on selling government debt at market interest rates. In the area of monetary management, this effort involved using indirect instruments of monetary policy such as open market operations instead of direct instruments such as interest rate controls or credit ceilings. ![]() Typically, reform of this requirement has been part of a broader effort by countries to make financial intermediation more efficient by relying more on markets and less on regulations. But, from a monetary standpoint, a liquid asset requirement is an inefficient instrument that may introduce serious distortions. In any case, liquid asset requirements have a significant monetary effect only to the extent that the assets used to satisfy them are a central bank liability or are issued and negotiated abroad. Under such circumstances, liquid asset requirements lead to inefficiencies and disintermediation and become increasingly ineffective for monetary control. When eligible securities carry below-market returns, financial flows tend to be diverted to markets or institutions that are exempted from the ratio. ![]() Several problems have typically led countries to undertake such a reform. Reform has included lowering liquid asset ratios to the minimum level necessary to manage cash flows and facilitate interbank settlements, allowing for averaging of liquid asset balances and including among the list of eligible assets those that can be realized in a relatively short time without significant loss of principal. However, the general trend has been to reform this instrument with a view to improving banks’ liquidity management. Recently, this requirement has been used in the context of currency board arrangements as a prudential instrument to help banks meet their systemic liquidity needs, given the limitations such arrangements set on the central bank’s ability to act as a lender of last resort. 1 In developing countries their use mainly reflects a mix of monetary and prudential purposes. Industrial countries have for the most part eliminated the use of a binding liquid asset requirement for monetary and prudential purposes. This requirement may be maintained on a day-to-day or on an average basis. The eligible range of assets varies, but usually includes cash, deposits with the central bank, correspondent accounts, and government securities. In a number of countries this requirement is calculated as a percentage of short-term liabilities. Creditors obviously won’t care about this much cash because they just want to make sure there is enough money to pay back the loans.A liquid asset requirement, or ratio, is defined as the obligation of commercial banks to maintain a predetermined percentage of total deposits and certain other liabilities in the form of liquid assets. For example, if cash represents 90 percent of a business’ assets, investors might speculate why these resources aren’t being used to grow the operations and invest in new capital. ![]() Poor liquidity is also a sign to investors that the company fails to efficiently generate revenues with its assets to meet its current obligations.Ĭreditors and investors usually prefer higher liquidity levels, but extremely high levels of liquidity could mean the company isn’t properly investing its resources. Companies that struggle with liquidity usually have a difficult time growing and increasing performance because short-term funding isn’t available. Investors, on the other hand, are typically more concerned with the overall health of the business and how it can increase performance in the future. Since creditors are primarily concerned with a company’s ability to repay its debts, they want to see there is enough cash and equivalents available to meet the current portions of debt. What Does Liquidity Mean?Ĭreditors and investors often use liquidity ratios to gauge how well a business is performing. Obviously, the most liquid asset of all is cash. In other words, liquidity is the amount of liquid assets that are available to pay expenses and debts as they become due. Definition: Liquidity refers to the availability of cash or cash equivalents to meet short-term operating needs.
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