What is Liquidity ?


Liquidity is defined as bank's capacity to pay cash in exchange of deposits. Liquidity needs of commercial banks are unique because in no other types of business there will be such a large proportions of deposits payable on demand.In other organizations too, liquidity is required for various purposes. Inadequate liquidity does damages credit-standing of those organizations but if bank fail to repay the deposits on demand, the bank loses the trust of the public. This leads to "run" in the bank and probably bankruptcy thereof.Liquidity is the lifeline of the bank.

Banks maintain liquidity in the form of:
- Cash and bank balance (primary reserve)
- Placements/money at call or short notice (secondary reserve)
- Investment in government securities and other securities readily convertible into cash (secondary reserve).

Since bank deal in various foreign currencies, liquidity refers to bank's capacity to pay off the liabilities in all those currencies. Maintaining excess liquidity in one currency while demand is for other currencies is not effective liquidity management because the liability in the demand currency can not be met.
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