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 a 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 seven 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 number 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 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.
