AQA Specification focus:
‘Liquidity ratios and capital ratios and how they affect the stability of a financial institution.’
Introduction
Liquidity and capital ratios are critical tools used to safeguard financial institutions, ensuring stability, reducing risk, and protecting the wider economy from systemic collapse.
Liquidity Ratios
Definition and Importance
Liquidity ratios measure a bank’s ability to meet its short-term obligations using its most liquid assets. This ensures that banks can satisfy deposit withdrawals and interbank payments without resorting to emergency borrowing or forced asset sales.
Liquidity Ratio: A financial metric that compares a bank’s liquid assets to its short-term liabilities, indicating its ability to meet immediate financial demands.
A strong liquidity position helps to maintain public confidence and prevents liquidity crises, where sudden withdrawals could destabilise the bank.
Types of Liquid Assets
Banks generally hold:
Cash reserves at the central bank.
Government securities such as short-dated bonds.
Highly marketable assets that can quickly be sold with minimal loss.
These assets allow banks to respond to unpredictable demands for cash.
Regulatory Standards
UK regulators, including the Prudential Regulation Authority (PRA), set minimum liquidity requirements.
These are influenced by international frameworks such as Basel III, which introduced the Liquidity Coverage Ratio (LCR).
The LCR requires banks to hold sufficient high-quality liquid assets (HQLA) to cover net cash outflows over a 30-day stress period.
Such rules aim to prevent a repeat of situations like the 2007–2008 financial crisis, where insufficient liquidity left banks unable to meet obligations.
Capital Ratios
Definition and Role
Capital ratios assess the strength of a bank’s capital base relative to its risk-weighted assets. Unlike liquidity, which focuses on cash flow, capital ratios ensure that a bank can absorb losses without collapsing.
Capital Ratio: A measure of a bank’s capital compared to its risk-weighted assets, used to determine financial resilience against potential losses.
Adequate capital provides a cushion that protects both depositors and the wider economy.
Risk-Weighted Assets
Not all assets carry the same level of risk. For example:
Government bonds are considered low risk and require little capital backing.
Corporate loans or mortgages carry higher risk and therefore require greater capital support.
This weighting ensures that banks cannot load up on risky assets without increasing their capital base.
Key Measures
Tier 1 Capital Ratio: Core capital (mainly equity and disclosed reserves) as a percentage of risk-weighted assets.
Common Equity Tier 1 (CET1) Ratio: The most stringent measure, focusing only on high-quality equity capital.
Total Capital Ratio: Includes Tier 1 plus supplementary capital such as subordinated debt.
These ratios are crucial benchmarks for regulatory compliance.
The Relationship Between Liquidity and Capital
Complementary Roles
Liquidity and capital ratios work together:
Liquidity ratios ensure the bank can meet short-term obligations.
Capital ratios ensure long-term resilience against losses.
Both are necessary for maintaining financial stability, and regulators monitor them simultaneously.
Trade-offs and Tensions
Banks face trade-offs when managing liquidity and capital:
Holding large amounts of liquid assets can reduce profitability since these assets often yield lower returns.
Maintaining high capital ratios may restrict lending capacity, as more equity funding is required.
Despite these costs, the benefits of resilience outweigh the short-term profitability losses, especially during periods of financial stress.
Impact on Financial Stability
Why Ratios Matter
Protecting Depositors: Strong ratios reduce the risk of bank runs.
Preventing Contagion: A well-capitalised and liquid banking sector minimises systemic risk.
Supporting Confidence: Markets and consumers are more likely to trust stable banks, lowering the chance of panic-driven crises.
Post-Crisis Reforms
Following the global financial crisis, regulators tightened requirements:
Introduction of Basel III standards.
Emphasis on higher CET1 ratios.
Stricter liquidity rules such as the LCR and the Net Stable Funding Ratio (NSFR), which promotes long-term funding stability.
These reforms aimed to create a more resilient financial system capable of withstanding shocks.
Equation: Bonding Ratios with Stability
Capital Adequacy Ratio (CAR) = (Tier 1 Capital + Tier 2 Capital) ÷ Risk-Weighted Assets
Tier 1 Capital = Core equity, retained earnings
Tier 2 Capital = Supplementary capital (e.g., subordinated debt)
Risk-Weighted Assets = Assets adjusted for risk level
This measure is used worldwide to determine whether banks have enough capital relative to the risks they are taking.
Maintaining a high CAR reassures regulators and markets that a bank has sufficient protection against losses, reinforcing system-wide confidence.
The UK Context
The Role of Regulators
Prudential Regulation Authority (PRA) sets and enforces capital and liquidity requirements.
Financial Policy Committee (FPC) oversees systemic risk, recommending macroprudential policies like countercyclical buffers.
Bank of England provides oversight and stress testing to ensure compliance.
These institutions collectively ensure that liquidity and capital frameworks safeguard the stability of the financial system.
FAQ
Liquidity risk arises when a bank cannot meet short-term obligations because it lacks enough readily available cash or liquid assets.
Capital risk refers to the danger that a bank’s capital base is insufficient to absorb unexpected losses from its assets, potentially threatening solvency.
Both risks are managed through regulatory requirements on liquidity and capital ratios, but they address different timeframes and vulnerabilities.
Regulators classify HQLA based on their ability to be quickly sold with little loss in value.
Level 1 assets: cash, central bank reserves, highly rated government bonds.
Level 2 assets: certain corporate bonds or covered bonds, but capped in proportion.
This classification ensures banks rely on the most stable and reliable assets to cover liquidity needs.
Risk-weighted assets recognise that not all loans or securities carry the same likelihood of default.
For example:
Government bonds often carry a weight of 0%.
Corporate loans may carry much higher weights.
This approach ensures banks hold more capital against riskier activities, discouraging excessive exposure to volatile assets.
The NSFR focuses on long-term stability, requiring banks to maintain sufficient stable funding over a one-year period.
While the Liquidity Coverage Ratio (LCR) ensures short-term resilience, the NSFR reduces reliance on volatile short-term funding, such as overnight borrowing.
Together, the two ratios encourage banks to balance short-term liquidity with sustainable funding structures.
Regulators can take corrective action, such as:
Restricting dividend payments.
Limiting risky lending activities.
Requiring capital raising or asset sales.
In severe cases, the bank may face intervention, restructuring, or even resolution procedures to protect depositors and financial stability.
Practice Questions
Define a capital ratio and explain why it is important for financial institutions. (2 marks)
1 mark for definition: A measure of a bank’s capital compared to its risk-weighted assets.
1 mark for explanation: Shows ability of a bank to absorb losses and remain stable.
(6 marks)
Discuss how liquidity and capital ratios contribute to the stability of the financial system.
1 mark: Reference to liquidity ratio ensuring banks can meet short-term obligations (e.g., deposit withdrawals).
1 mark: Explanation of liquid assets such as cash reserves or government securities.
1 mark: Reference to capital ratio ensuring banks can absorb long-term losses.
1 mark: Mention of risk-weighted assets and why capital backing varies by risk.
1 mark: Connection to financial stability, e.g., preventing bank runs, protecting depositors, reducing systemic risk.
1 mark: Link to regulatory frameworks such as Basel III requirements (CET1 ratio, Liquidity Coverage Ratio).
