# Liquidity Risk - “The wise banker's aphorism”

once I read about the wise banker's aphorism. It says: "Too little liquidity may kill the bank suddenly, but too much liquidity kills the bank slowly and surely".

The first part of this sentence is pretty clear, but I don't get the meaning of the second one. Why should too much liquidity put at risk a bank's stability?

• might mean that if the bank is very liquid, if is not lending out money efficiently, its net interest margins would drop, overtime the cost of capital would rise beyond the gross margin and would kill the bank ! – nimbus3000 Mar 23 '17 at 10:02
• I don't understand how a negative net interest income might cause an increase in the cost of capital. And then, why would the latter rise over the gross margin? I don't get the link among these three variables. Can you be more clear? – Giano Rugge Mar 23 '17 at 11:21
• So, negative interest income might cause investor to be more worried about the company and thus increase the cost of capital. overtime, if this situation persists, gross margin might keep reducing as one would need to pay higher interest cost..all assumption and hypothesis though – nimbus3000 Mar 23 '17 at 13:53
• Being the cost of capital equal to the sum of the cost of equity plus the cost of debt, it's clear why the cost of capital might increase. But I don't get yet why the gross margin would increase. The latter is equal to revenues minus COGS over revenues, isn't it? So which of the variables involved is decreasing or increasing in order to get an overall drop of gross margin? – Giano Rugge Mar 23 '17 at 14:43
• I meant the gross margin would reduce, if the top line remains same and everything else goes up, bottom line falls – nimbus3000 Mar 23 '17 at 14:54

In my interpretation "liquidity" is a reference to the amount of liquidity on the balance sheet of the Bank. (Not to the external environment, or to financial innovation). A Bank can reduce risk by avoiding lending and keeping lots of short term government securities on the left side of its balance sheet. By doing this it will sail through crises like those that took down Barings in 1890 or Lehman Bros. in 2008. But in the long run it will earn very little or nothing for its shareholders and will be outcompeted by banks that deploy their capital more intelligently. Yes, maturity transformation is dangerous, but without it you earn the T-Bill rate which is in the long run only a few basis points higher than the rate of inflation. So my answer is the same as Nimbus 3000, you have to take some risk or you won't earn a decent return.

• It is not so much maturity transformation that is dangerous (after all, that is a bank's business!) but reckless maturity transformation. In a rich liquidity environment $-$ e.g. very liquid wholesale funding markets $-$ banks might lower their risk standards and keep decreasing the average maturity of their liabilities while increasing the average maturity of their assets to increase the maturity spread they earn. Post-Crisis the Bale Committee on Banking Supervision has introduced the Net Stable Funding Ratio (NSFR) to control the degree of maturity transformation being performed by banks. – Daneel Olivaw Mar 23 '17 at 12:41
• You are brilliantly describing the situation where the Bank is "killed suddenly" (too much risk, too much outside funding). I am illustrating with a simple example the case where the Bank fails slowly and imperceptively due to lack of a sufficient Interest Margins and an overcautious attitude. The Aphorism is about balancing these two contradictory ideas. – noob2 Mar 23 '17 at 13:03

My interpretation of this statement is that abundant availability of liquidity and funding will push banks to adopt reckless strategies, especially in terms of maturity transformation $-$ i.e. borrowing short-term and lending long-term to earn a spread $-$, leaving them exposed to a sudden liquidity impact which could dry their short-term financing sources and plunge them into a liquidity crisis.

Take for example the years preceding the 2008-2009 Financial Crisis. At the start of the 2000's, commercial and investment banks became more and more dependent on wholesale funding, provided primarily by institutional investors (pension funds, insurance companies, investment funds, etc.). Compared to the relative stickiness of retail deposits, wholesale liquidity tends to be short-term, highly volatile and sensitive to the credit profile of the borrower: as soon as doubts arise concerning the solvability or liquidity position of the borrower, participants in the wholesale funding market might abruptly withdrawn, leaving the borrower exposed to a liquidity shortage.

Banks dependence on the wholesale funding market kept increasing during the 2000's, as it was a cheap financing source allowing them to earn profitable spreads between their short-term borrowing and their long-term lending. One of the offspring of this trend were Structured Investment Vehicles (SIV): you might have heard about Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO) and how they contributed to the Financial Crisis; well, large part of their impact was through the SIV channel.

A SIV is similar to a MBS or a CDO: instead of mortgages, SIV package together other MBSs and CDOs into a legal shell; the shell then issues short-term notes (commercial paper) to investors, which interest is paid through the coupons received from the underlying MBSs and CDOs. Because maturities were very short, the SIV required refinancing very regularly: new short-term notes would be issued, which would allow to repay preceding investors. In case of financing gaps, the bank backing the SIV $-$ i.e. setting up and managing the SIV $-$ would be standing to refinance the structure and repay the notes' principal.

As you might have guessed, during the Crisis, uncertainty about the liquidity and solvability position of some banks led institutional investors to withdrawn from the wholesale funding market, and one consequence was that banks were left exposed to their off-balance sheet SIV and the resulting financing needs; some of these institutions (Bear Stearns, Lehman Brothers) didn't manage to survive the crisis and were indeed "killed [...] slowly and surely".