How Excess Balance-Sheet Liquidity Can Weaken Banks
Summary
The discussion gives two interpretations of the claim that excessive liquidity can harm a bank. One focuses on low returns: a bank that holds short-term government securities instead of lending may be safer in a crisis, but can earn too little to remain competitive over time. The other focuses on incentives and funding structure: abundant, cheap funding can encourage banks to borrow short term and lend long term to earn a spread.
The answer illustrates the second risk with wholesale funding and structured investment vehicles before the 2008–2009 crisis. These vehicles relied on repeated short-term borrowing against longer-term assets, while sponsoring banks could face pressure to provide support if refinancing failed. The discussion is explanatory rather than empirical, and it presents interpretations of the aphorism rather than proving a general causal rule. Its examples show how funding withdrawals can turn apparent liquidity abundance into a vulnerability.
Key ideas
- Holding safe, liquid assets can reduce crisis exposure while limiting a bank’s earnings.
- Cheap short-term funding may encourage maturity transformation and greater funding risk.
- Wholesale funding can be less stable than retail deposits when confidence weakens.
- Banks that sponsor short-term funded vehicles may face contingent financing needs.
Tags
Full text
# Liquidity Risk - "The wise banker's aphorism" # Liquidity Risk - "The wise banker's aphorism" once I read about the wise banker's aphorism. It says: "Too little liquidity may kill the bank suddenly, but too much liquidity kills the bank slowly and surely". The first part of this sentence is pretty clear, but I don't get the meaning of the second one. Why should too much liquidity put at risk a bank's stability? Thank you in advance. ## Answer by nbbo2 (score 0, accepted) https://quant.stackexchange.com/a/33192 In my interpretation "liquidity" is a reference to the amount of liquidity on the balance sheet of the Bank. (Not to the external environment, or to financial innovation). A Bank can reduce risk by avoiding lending and keeping lots of short term government securities on the left side of its balance sheet. By doing this it will sail through crises like those that took down Barings in 1890 or Lehman Bros. in 2008. But in the long run it will earn very little or nothing for its shareholders and will be outcompeted by banks that deploy their capital more intelligently. Yes, maturity transformation is dangerous, but without it you earn the T-Bill rate which is in the long run only a few basis points higher than the rate of inflation. So my answer is the same as Nimbus 3000, you have to take some risk or you won't earn a decent return. ## Answer by Daneel Olivaw (score 1) https://quant.stackexchange.com/a/33190 My interpretation of this statement is that abundant availability of liquidity and funding will push banks to adopt reckless strategies, especially in terms of maturity transformation $-$ i.e. borrowing short-term and lending long-term to earn a spread $-$, leaving them exposed to a sudden liquidity impact which could dry their short-term financing sources and plunge them into a liquidity crisis. Take for example the years preceding the 2008-2009 Financial Crisis. At the start of the 2000's, commercial and investment banks became more and more dependent on wholesale funding, provided primarily by institutional investors (pension funds, insurance companies, investment funds, etc.). Compared to the relative stickiness of retail deposits, wholesale liquidity tends to be short-term, highly volatile and sensitive to the credit profile of the borrower: as soon as doubts arise concerning the solvability or liquidity position of the borrower, participants in the wholesale funding market might abruptly withdrawn, leaving the borrower exposed to a liquidity shortage. Banks dependence on the wholesale funding market kept increasing during the 2000's, as it was a cheap financing source allowing them to earn profitable spreads between their short-term borrowing and their long-term lending. One of the offspring of this trend were Structured Investment Vehicles (SIV): you might have heard about Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO) and how they contributed to the Financial Crisis; well, large part of their impact was through the SIV channel. A SIV is similar to a MBS or a CDO: instead of mortgages, SIV package together other MBSs and CDOs into a legal shell; the shell then issues short-term notes (commercial paper) to investors, which interest is paid through the coupons received from the underlying MBSs and CDOs. Because maturities were very short, the SIV required refinancing very regularly: new short-term notes would be issued, which would allow to repay preceding investors. In case of financing gaps, the bank backing the SIV $-$ i.e. setting up and managing the SIV $-$ would be standing to refinance the structure and repay the notes' principal. As you might have guessed, during the Crisis, uncertainty about the liquidity and solvability position of some banks led institutional investors to withdrawn from the wholesale funding market, and one consequence was that banks were left exposed to their off-balance sheet SIV and the resulting financing needs; some of these institutions (Bear Stearns, Lehman Brothers) didn't manage to survive the crisis and were indeed "killed [...] slowly and surely".
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.