Liquidity, Risk and Profitability

Remember, a bank is a firm and needs to make a profit..

Banks are just like any other firms.  We assume they are trying to profit maximise, at least in the long term. They are trying to satisfy the need and wants of the shareholders.

Banks use the money that they have to generate profit for their shareholders. Banks can hold their money in liquid and illiquid form...

The rate of return (the percentage that is made on top of what you invest) is generally higher for illiquid assets than it is for liquid assets...

This means a bank would ideally like to hold illiquid assets like shares and houses as they can generate more profit. If banks hold their wealth in liquid form, this means that profitability will be limited.

How do banks purchase illiquid assets?

Banks receive liquid money from depositors. The banks do not expect people to withdraw their money in full immediately. Therefore, they take deposits and buy other illiquid assets to store their wealth.

The problem with this is that if banks are too illiquid, then they have less liquid money (cash) to repay their depositors when the time comes.

That means that banks need to find a good balance between liquidity and profitability.

If they hold too many illiquid assets, they will be unable to fulfill their obligations to the depositors.

If they hold too many liquid assets, they will be unable to fulfill their obligations to the shareholders and generate maximum profit.

It’s very unlikely that depositors will all demand their money back in one go. However, if people feel like their savings are at risk for any reason, this can trigger a bank run. A bank run will surely shut a bank down.

Therefore, this problem can only be remedied if people trust the banking system. This is also why a central bank is also considered to be the “lender of last resort”. In an emergency, a bank can approach the central bank and ask for an emergency loan so they can pay their depositors.

Risk can lead to profitability

Generally, higher rewards are paid to those who take higher risks. Investors want higher rewards for risking their money. That’s why higher risk investments carry higher rewards like interest rates/dividends etc. Low risk forms of investment will carry low rewards like saving money in your ISA.

Therefore, banks need to analyse risk and make sure the investment makes financial sense. They need to ensure the profitability of the investment is in line with its riskiness.

In summary, we have learned:

Liquid and illiquid assets

Balancing liquidity and risk with profitability

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