Monetary Policies: Liquidity Ratio explained in lay terms

                                

Still on the topic; tools for money control or monetary policy, we discuss liquidity ratio

What is liquidity?

Liquidity is the speed with which financial assets can be converted into cash. For instance, a recharge card is not cash but I can easily come out on the street and sell it to someone who needs it and the person pays me cash; therefore the recharge card is Liquid because its liquidity is high, it can be easily converted into cash. On the other
hand something like land is not so liquid because it cannot easily be converted to cash, before you can sell your land or convert it to cash, there are paper works that have to filled and so many other processes, for this reason, land is not a liquid asset.

When it comes to banking system, the liquid assets are those documents that can be easily converted into cash such as Cheques, withdrawal slips, bank drafts, bank account deposits, ATM cards, bills of exchange and cash itself. These are all liquid assets that a bank has and which can be easily converted to cash, by the bank itself or by the customers of the bank. The banks use bills of exchange to borrow and collect cash from each other easily while customers can easily write cheques, use withdrawal booklets, bank drafts or use the ATM cards when they need cash.

Banks are not allowed to keep all their assets in these liquid forms, they only maintain a percentage in liquid forms while other assets are channeled to non-liquid assets. It is clear from this point that the more liquid assets a bank is able to have, the easier they can circulate money to their customers and vice versa. So this means that the HIGHER the LIQUIDITY RATIO, the EASIER it is to give out money. The LOWER the LIQUIDITY RATIO, the HARDER it will be for banks to give out money. In essence, a higher liquidity ratio means an EXPANSIONARY POLICY while lower liquidity ratio means a CONTRACTIONARY POLICY.

The monetary policy meeting pegged the liquidity ratio for this year at 30% which is the same figure as last year. So banks are only allowed to keep 30% of their assets in liquid form, while 70% goes into Non-liquid assets. This will clearly limit the ease with which banks give out money. This is all in pursuance of the CBN’s COTRACTIONARY POLICY.

The big question… what if more customers need money and the 30% liquidity is not enough for all its customers?

In such a case, the bank will have to borrow from other banks or from the CBN. This will be explained better in a later post when we shall discuss bank rates. Drop your questions and comments below.