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April 15, 2020

Declog the spigot

Addressing liquidity risks posed by Covid-19



The economic disruption brought on by the Covid-19 pandemic offers many a parallel with the Global Financial Crisis of 2008, but it is also unprecedented in many ways.


The 2008 crisis had posed significant liquidity crisis and raised fundamental questions on the capability of banks to endure these. Indeed, this had prompted the Basel III regulations to be designed, with an aim to enhance regulation and tighten monitoring to address liquidity risks and thereby ensure financial stability.


Much of it applies to the current crisis, too, to the extent that economic distress typically manifests through disruptions in the basic demand-supply dynamics. However, the novelty this time around lies not so much in the nature of economic distress, but in the way it has originated and continues to spread.


The worst aspect of it is that the severity of the pandemic’s impact and the timeframe of the lockdowns are unknown. The situation might worsen unless a vaccine becomes available soon. In that case, businesses might encounter severe liquidity crunch as supply of short-term funds might be severely crippled.


True, the measures implemented and liquidity buffers reserved as a consequence of the earlier economic crisis might serve as a cushion and mitigate the situation to an extent. Only this time, liquidity is required to not only cater to the economic downfall, but also to be diverted to ensure safety of people. In short, unlike earlier, funds have to be optimally utilised to save both life and livelihood.


To tackle the liquidity risk and boost liquidity in banks, global regulatory bodies have temporarily exempted banks from fulfilling additional capital and liquidity requirements.


At this stage, it is crucial to decide the optimum liquidity buffers to be reserved in order to cater to the current liquidity needs and to ensure the institutions do not enter the vicious circle of liquidity risk.


This note throws light on how the current pandemic can impact liquidity in banks and how global regulatory bodies are dealing with it. It also suggests some precautionary steps in case the situation worsens.