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A statutory liquidity ratio is a type of financial calculation that involves determining the total amount of liquid assets that an institution must hold in reserve in order to operate in compliance with banking regulations set in place by a national government. The types of assets involved in this reserve may be cash, precious metals, or other types of approved securities that are found on listings provided by the appropriate regulatory agency. Cash that is required for operation by a central bank is usually not included among the liquid assets that constitute the statutory liquidity ratio.
While there are some variations on the formula for determining the statutory liquidity ratio, just about any approach will involve identifying some percentage of the total demand and time liabilities related to the bank operation. Time liabilities are simply the liabilities of the institution that are payable on demand at any given time, along with any liabilities that are accruing in a month’s time period due to maturity of those liabilities. The sum total of the demand and the time liabilities are multiplied by an identified percentage, providing the statutory liquidity ratio and defining the amount of assets that must be kept on hand.
There are several reasons why some nations have some type of statutory liquidity ratio in place. One has to do with having some control over the level of bank credit that is issued by a specific institution. By using the ratio to identify limits that are not likely to increase the odds of the bank failing, the government helps to protect both consumers and the economy in general. At the same time, a statutory liquidity ratio goes a long way toward helping to protect any investments that government agencies have in those financial institutions. Creating a cash reserve ratio that is considered equitable in terms of the current economic conditions means that the chances of bank insolvency are kept to a minimum, and the potential to move through an economic downturn with less overall damage is improved.
In terms of setting the statutory liquidity ratio, most governments will assess the assets of the financial institution and identify a specific amount of assets that must be earmarked as financial reserves, other than those associated with a central bank. Doing so helps to not only protect the interests of consumers, but also provides the government with one more way to help move the economy in the most desirable direction possible. The ratio can be increased when there is a need to slow the forward momentum of inflation, and can be decreased when the goal is to move the economy through and eventually out of a recession by promoting financial growth within the country.
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