Liquidity explained

Liquidity refers to the ease at which assets can be converted into cash.

  • An asset is said to be liquid, if it is easy to buy and sell; for example short-date government gilts are a highly liquid market because it is easy to sell on the bond markets.
  • As asset is said to be illiquid if it is difficult to buy and sell. For example, a house is a very illiquid asset because to sell a house requires considerable time and expense. By the time you have found a buyer, the price of a house may have changed considerably – especially during boom and busts.

The importance of liquidity

An investor may need both liquid and illiquid assets. You need liquid assets to deal with any unexpected short-term crisis. But, illiquid assets may offer greater chance for capital gains and higher yield.

For example, if you put money in a current account, you have instantaneous access, but interest rates tend to be low. If you put money in a time deposit account, you have to give the bank a 7 day or 30 day advance warning you need the money. This makes your savings more illiquid, but the bank compensates by paying a higher interest rate.

Liquidity ratio

A liquidity ratio refers to the amount of liquid assets to overall assets. If a firm is highly liquid – it has a high proportion of assets that can easily be converted to cash to pay off any obligations.

A low liquidity ratio means a firm has a shortage of liquid assets and may struggle to meet short-term debt obligations.

Cash reserve ratio

A bank may be required to keep a certain percentage of its assets in the form of liquid assets. It is the fraction of customer deposits held in cash reserves.

Cash reserves are not profitable. If a bank lends deposits to other customers, it can charge interest and make more profit. But bank loans are highly illiquid because the bank cannot immediately ask for the loan back.

Bank Liquidity measured by Bank of England
Bank Liquidity fell to a record low in 2005.

A problem of the credit crisis is that banks had a very low cash-reserve ratio. This led to a liquidity crisis when banks couldn’t raise sufficient funds on short-term money markets.

Liquidity and insolvency

Sometimes firms or governments may find they face a liquidity crisis – even though fundamentally they have a decent financial position.

For example, a firm may in theory be profitable – its revenue is greater than its costs. However, if the firm has not received its income due – because of later payers, it can find itself with a cash-flow problem. It doesn’t have enough income to meet current bills. This is a liquidity problem. Given time, it could sell assets and collect the late payments. But in the short-term it lacks liquidity.

On the other hand, if a firm has revenue substantially below costs, it will become insolvent in the long-term. The problem is more than just a liquidity problem.

See also: Difference between liquidity crisis and insolvency

Euro crisis

In the Euro crisis, several European economies, such as Ireland and Italy suffered a liquidity crisis – they couldn’t borrow on short-term money markets to finance their current shortfalls because of a lack of confidence.

In the UK, we had higher levels of government borrowing. But, because the UK had a Central Bank able to print money – we had greater liquidity and investors had more confidence. Therefore the UK didn’t face a liquidity shortage.

Liquidity trap

When a cut in interest rates fails to stimulate consumer spending because consumers prefer to hold money (liquid assets) rather than spend and buy illiquid goods. See: Liquidity trap explained

 

3 thoughts on “Liquidity explained

Leave a Reply

Your email address will not be published. Required fields are marked *