In layman’s terms liquidity means holding cash at disposal. Banks need liquidity primarily for enabling the depositors to withdraw deposits on or before maturity in order to maintain confidence of the depositors. The term ‘liquidity’ is defined for a bank as “the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses” by the Basel Committee on Banking Supervision (2008). In the above definition, the term “without incurring unacceptable losses” tallies with the term “at a reasonable cost” in the definition of ‘liquidity’ provided by the Reserve Bank of India (2012). With the above ability a bank manages the mismatches in the volumes between the maturing liabilities and the maturing assets at the end of different common terms to maturity. If such mismatch affects the cash availability in a bank for the depositors at any point of time it would lead to bank-run. In this context Sethuraman (2008) distinguished between liquidity and solvency as follows. Solvency means a non-zero net worth. Even on the day of the bank-run it is possible for a bank to be highly solvent without having any cash or liquidity. In the day to day business of a bank, liquidity is an index of how fast it can convert the assets into the cash without any loss and/or how fast it can raise the wholesale funds from the unsecured interbank market without facing any hike in the payable interest for any reason unique to itself.
During the financial year (FY) 2011-12 of economic downturn characterized typically by economy wide loan defaults many banks in India are reported to have posted adequate levels of capital but experienced difficulties due to unsound liquidity management. Hence the rest of the paper contains the concepts of liquidity with which the Indian commercial banks and the central bank of the country, viz, the Reserve Bank of India (RBI) are operating in their daily life, the nature liquidity management therein and the circumstances that lead to stresses facing the banks in their process of liquidity management. Finally this paper critically examines whether the RBI facilitates liquidity management of the banks during the stress periods in the interbank market.