To understand the importance of liquidity to a bank, let's consider a very simple bank. Let's say it has 100 of assets in the form of loans and liquid assets totaling 90 and 10 respectively. The liquid assets of a bank can take several different forms, but all share the following characteristic. They're able to be converted to cash quickly and easily, or in other words, they are liquid.

Cash is the ultimate type of liquid assets, but other examples include short term government bonds from highly rated countries such as the US or the UK, or other money market securities such as certificates of deposits. Loans, on the other hand, are not very liquid. Any loan that a bank issues will have a set repayment date or which the money is scheduled to be returned to the bank, where the bank doesn't have the right to ask for this money to be paid back early. Loans are also not easily tradable either. This makes it difficult for the bank to turn a loan into cash should it need that money to pay its liabilities.

It is possible under certain circumstances for a bank to sell a portion of its loan portfolio, but this isn't something the bank can do quickly if it is in urgent need of cash to meet its liabilities. This illiquidity of loans is part of the reason why a bank will earn a higher return from loans than from the liquidity portfolio.

Now let's have a look at the funding of these assets. Let's say that these 100 of assets were funded by 50 of deposits, 45 of debt financing i.e., the bank has borrowed from another institution and 5 of shareholder equity, which is also called equity capital. The capital of a bank is subject to strict regulatory requirements to ensure there is enough equity capital to protect the bank from bankruptcy if there were any losses from its loan portfolio. This is where the equity capital acts as a buffer to absorb those losses while still leaving the bank with enough funding to meet all of its liabilities. This was the main focus of the rules of Basel I and Basel II, protection from losses of a bank's assets.

However, this is not the only reason that a bank can fail if there are fears about a bank's ability to continue, for example, as a result of a large number of loans being written off. Even if these losses were Were covered by the bank's, equity capital depositors may still withdraw their cash, or debt financiers to the bank may not be willing to refinance any debt that was due for repayment. In these instances, it would not be losses on the assets that would ultimately cause the bank to fail, but rather an inability to transform enough of its assets into liquid assets to be able to meet cash outflow requirements.