Liquidity

1.There is a statement in Module 18 which says that by issuing CDs (illiquid liability) a bank can increase the proportion of its illquid assets without increasing the maturity gap.

Lets say that the maturity period of the CDs is one year.
So to keep the maturity gap intact should my new illiquid assets also be of the same maturity period?

2.a If banks collectively hold a lower liquidity ratio, they will have surplus liquidity.
b.By using the liquid assets for credit creation, the banking system is operating with a overall liquidity ratio.
Please Explain.

 

By issuing and selling CDs for cash, a bank can increase its liquid assets (cash), whilst increasing its illiquid liabilities (new CDs). This will therefore reduce the average maturity gap between its (mostly illiquid) assets and its (mostly liquid) liabilities. This reduced maturity gap offers it the possibility of issuing more illiquid assets (loans), without increasing its maturity gap above its initial value.

In general, however, banks typically have longer-term assets than liabilities and hence a positive maturity gap. If this is the case, then issuing equal amounts of a one-year liability (eg CD) and a one-year asset, will tend to reduce the average difference between the terms of the assets and liabilities and hence reduce its overall maturity gap.

Yes, it is true that if banks collectively hold a lower liquidity ratio, they will have surplus liquidity. They will generally use this surplus liquidity to increase lending, ie for credit creation.

In addition, if each bank holds a lower liquidity ratio, then the overall liquidity ratio of the banking system will be lower. As the Core Reading says, the liquidity ratios of banks will vary over time, eg seasonally, in response to financial innovation and/or depending on overall credit conditions and the mix of liquid assets that they hold.

 

How by holding lower liquidity ratio can banks have liquidity surplu?