Liquidity for a bank means the ability to meet its financial obligations as they come due. Bank lending finances investments in relatively illiquid assets, but it funds its loans with mostly short term liabilities. Thus one of the main challenges to a bank is ensuring its own liquidity under all reasonable conditions.
Asset Management Banking
Commercial banks differ widely in how they manage liquidity. A small bank derives its funds primarily from customer deposits, normally a fairly stable source in the aggregate. Its assets are mostly loans to small firms and households, and it usually has more deposits than it can find creditworthy borrowers for. Excess funds are typically invested in assets that will provide it with liquidity such as Fed funds loaned and U.S. government securities. The holding of assets that can readily be turned into cash when needed, is known as asset management banking.
Liability Management Banking
In contrast, large banks generally lack sufficient deposits to fund their main business -- dealing with large companies, governments, other financial institutions, and wealthy individuals. Most borrow the funds they need from other major lenders in the form of short term liabilities which must be continually rolled over. This is known as liability management. a much riskier method than asset management. A small bank will lose potential income if gets its asset management wrong. A large bank that gets its liability management wrong may fail.
Key to Liability Management
The key to liability management is always being able to borrow. Therefore a bank's most vital asset is its creditworthiness. If there is any doubt about its credit, lenders can easily switch to another bank. The rate a bank must pay to borrow will go up rapidly with the slightest suspicion of trouble. If there is serious doubt, it will be unable to borrow at any rate, and will go under. In recent years, large banks have been making increasing use of asset
management in order to enhance liquidity, holding a larger part of their assets as securities as well as securitizing their loans to recycle borrowed funds.
A bank run is an overwhelming demand for cash by a bank's depositors. With the advent of deposit insurance, bank runs by small depositors are largely a thing of the past. Insurance is limited to $100,000 per deposit, which provides complete coverage to about 99% of all depositors. But it covers only about three-fourths of the total amount of deposits because many accounts far exceed the insurance limits.
A large depositor assumes a risk and needs to know something about the bank's own balance sheet. However a healthy balance sheet does not eliminate all risk. Even if the depositor knows the bank has adequate liquidity, others may not. Large depositors must therefore be concerned about what others are likely to believe. A rumor about a bank, even though unfounded, can trigger a run that causes a solvent bank to fail.
The problems with deposit insurance could be solved by restricting its coverage to risk-free narrow banks or narrow deposits. A narrow bank would offer checking deposits and would be allowed to invest only in safe liquid assets such as T-bills. It could operate as a separate institution or as a subsidiary of a bank holding company. Only narrow banks would be eligible for deposit insurance.
Narrow deposits would be checking deposits that could be offered by any licensed institution on condition that they were secured exclusively by safe liquid assets. Only narrow deposits would be eligible for deposit insurance. Thus narrow banks or narrow deposits would be fully collateralized, and deposit insurance would be redundant and unnecessary. Ending deposit insurance would greatly reduce the moral hazard problem in banking.
Both of these alternatives are closely related to the concepts presented in the article The Case for a Single National Depository.