What are Banking Liquidity Ratios and Why Should You Care?
Contributed by Luigi Wewege At Caye International Bank
06 May, 2020
If you're not familiar with the concept of a banking liquidity ratio, don't feel alone. The average bank customer may have only heard the term in passing.
Fortunately, this is an aspect of banking and finance that's easy to grasp. It's also one that you need to keep in mind as you decide which institutions will be taking care of your hard-earned money.
Here is some information that will help you understand bank liquidity ratios and why they should factor into your decision about where to bank.
The Basic Definition of Liquidity Ratio
A liquidity ratio has to do with the amount of cash and cash assets that a banking institution has on hand for conversion. Not all assets are classed as cash assets. For the purposes of calculating a liquidity ratio, a bank would consider only those assets that could be sold off and increase the cash on hand within a specified period of time. While there are some parts of the world where that window for conversion is longer, many countries use 30 days as the standard.
The ratio itself measures the amount of liquid assets against the financial obligations that the bank must meet within that defined window of time. In other words, if every obligation to depositors as well as creditors were called due immediately, would the bank have enough assets to honor them and remain open?
One way to understand how the ratio works is to consider what took place during at the onset of the Great Depression of the 1930's. At the time of the stock market crash, many people rushed to withdraw their funds from bank accounts. The result is that some banks were unable to comply and had to close their doors. The banks that were able to continue functioning had enough resources that could be used to immediately meet the demand.
Understanding the Two Types of Liquidity Ratios
There's more than one type of liquidity ratio that determines the financial health of a banking institution. Each of them deserves close attention:
1. The Current or Working Capital Ratio: This type of liquidity ratio has to do with how well the bank could settle all debt within a short amount of time. That timeframe may be defined as one calendar month or it could be as long as one calendar year.
The focus is on how much cash is on hand currently as well as assets that could be converted into cash in time to settle all outstanding debt. In an ideal situation, the bank would be able to meet most obligations using the cash on hand and only need to convert a percentage of assets.
2. The Quick or Acid Test Ratio: This type of liquidity ratio focuses on the bank's ability to cover all immediate debt obligations using cash and convertible assets. Unlike a current ratio, the quick ratio is not concerned with paying off all debt in a short period of time. It's about meeting obligations that are immediately pending.
This could include covering upcoming installment payments on equipment or making at least the minimum payment on any revolving accounts related to the bank's operation. It could also involve crediting customer bank accounts with interest that's due and other financial matters that must be covered within a period that's typically no longer than a month. Think of it as a quick way to determine that the bank has the resources to keep operating in the short term, without having to leave any essential obligation unpaid.
What's a Desirable Liquidity Ratio?
Generally speaking, a higher liquidity ratio is in the best interests of consumers. That higher ratio indicates the institution is in a better position to weather economic shifts or continue to operate if changes in the political climate should develop. To some degree, that higher ratio also shows that the bank would be in a position to keep operating in the event of some catastrophic event like a natural disaster or a worldwide pandemic.
As you consider options for domestic and offshore banks, the most desirable liquidity ratio is one that exceeds what you can find at other institutions. Simplistically, the higher the liquidity ratio, the lower the perceived risk of the bank. If the plan is to open accounts and generate interest on the balances, you definitely want to know the bank's current liquidity ratio.
How Do I Go About Confirming a Bank's Ratio?
The process for confirming a bank's liquidity ratio is not difficult. In most instances, all that's required is to ask the question. This is the type of information that banks want prospective customers to know. Once the question is asked and answered, it's possible for bank personnel to point out what the institution has to offer because of that strong ratio.
Asking the question regarding an institution's liquidity ratio to a bank officer is the simplest approach. You can ask the question in person, via email, or you may even be able to find the information on the bank's website. Remember that since liquidity ratios can and do change over time, it never hurts to ensure that the figure received is current.
Do Liquidity Ratios for Offshore Banks Vary?
Many nations have standards that banking institutions operating within their borders must meet. Setting a minimum liquidity ratio is among those standards. Around the world, you will see different figures related to various countries. As an example, offshore banks in Belize must maintain a liquidity ratio of 24% whereas in other nations they may require a ratio of 10% or even less.
Keep in mind that a lower ratio doesn't mean the bank is facing imminent failure. Even so, it's a good idea to focus your attention on banks that do have a higher ratio since it means they are more likely to remain open and keep serving your accounts even if severe changes do take place.
Not All Banks are Created Equal
The bottom line is that not all banks can offer the same level of protection. As you seek to find the best domestic bank for your use, do ask about the institution's liquidity ratio.
Should you decide to establish accounts with an offshore institution, do the same. You'll find that reputable international banks are happy to provide this type of information to prospective clients.
If you are interested in setting up offshore accounts, contact Caye International Bank today. We can help you learn more about available offshore banking and our different account options and, with a liquidity ratio of 24%, you can rest easy knowing your funds are safe with us.
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