Liquidity: The term liquidity means the capacity of the bank to give cash on demand. In other words, it is the ability of the banker to satisfy the demand of customers for cash in exchange for deposits. Liquidity depends on the availability of liquid assets. Liquid assets are those assets which can be easily converted into cash without loss. More the liquid assets, greater will be the liquidity and vice versa.
Composition of liquid assets
The liquid assets of a bank are composed of the following:
1. Cash in hand.
2. Cash balance with other banks.
3. Cash balance with other banks.
4. Money at call and short notice.
Significance of liquidity
The term liquidity has special significance in banking business. The deposits accepted by a bank are largely payable on demand. In other words, the depositor has the right to withdraw money as and when they needs. The banker must pay his depositors on demand. In case a bank fails to pay cash on demand to the depositors on account of shortages of liquid cash, it may lose the trust and confidence of the public which will ultimately result in the closure of the bank. Thus, the banker must safeguard his position by maintaining sufficient liquid assets with him to meet the demand of the depositors for cash.
Factors determining the cash balances or liquidity of a bank
The following factors help the banks to decide the quantum of cash balances to be maintained:
1. Banking habit: Banking habits play a significant role in determining the cash balances of a bank. Banking habits refers to the utilisation of banking services by the public. If the people have e-banking habits then the use of cash in transaction is reduced and the banks need to keep lesser amount of liquid cash.
2. Structure of banking: The banking structure of the country also influence the liquidity requirements of the bank. In a branch banking system, the banks can function with less cash reserves because in case of emergency cash can be transferred from one branch to another. Whereas in unit banking system higher cash reserve is required.
3. Nature of bank accounts: The nature of deposit accounts viz. savings, current or fixed accounts affect the amount of cash balance to be kept by the banks. In case of fixed deposit account holders, the bank can manage with less cash balance as against current account where it must keep a larger cash balance.
4. Type of depositors: The type of depositors is another determinant of cash balance of the banks. If the majority of the depositors of the bank are business firms, corporations, schools, college etc. the bank will have to maintain high liquidity because of unpredictable. On the other hand, if the deposits are mostly by individual customers and are of personal nature, the bank can operate with less liquid cash.
5. Nature of advances: The nature of advances of bank i.e. loans, cash credit, overdraft and purchasing and discounting of bills also affect the size of the cash balances of the bank.
6. Seasonal requirements: The banks have to take into consideration the seasonal requirements of credit from the customers. It is an established fact that during busy seasons e.g. festivals, sowing, harvesting etc. seasons, there is increased demand for credit. Hence, the banks should keep large amount of cash.
7. Nature of business condition: The prevailing business condition in the country has its influence on the cash balances of a bank. When the condition is good, there is greater demand for cash. On the other hand, when the business is dull there is less borrowing from the banks.
8. Existence of clearing house arrangements: Cash balance of a bank also depends upon the availability of clearing house facilities. Clearing house settles inter-bank claims. If there is a clearing house, inter-bank claims can be easily settled and the banks need not keep large cash balances.