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Understanding the Concept of Liquidity

Liquidity refers to the company’s ability to convert its assets to cash in order to pay all liabilities that are due. From understanding the importance of liquidity management to assessing the significance of liquidity risk, read this wiki page for a constructive insight into the entire concept.

What Is Liquidity?

Liquidity is the term of economics which determines the rate at which cash flows in the market. It means the rate at which you can get your cash whenever you need it. During favourable market conditions or a lean season, you can get your money whenever you need without any delay. Thus, liquidity can be defined as the savings account which you can access at the time of an unexpected happening or an emergency. Liquidity also plays a crucial role in controlling inflation as inflation majorly depends upon the liquidity flowing in the market. All the fund you collected lifetime becomes useless if you cannot access it conveniently in the hour of need. Some liquid assets like cash, savings account, a checkable account can be easily converted into cash depending on your need.

Liquidity refers to the highest degree to buy or sell an asset or security in the market without affecting its price. Moreover, it is the maximum limit to which a market allows trade of the assets at stable prices. Among numerous assets, cash has successfully achieved the maximum number of votes to conquer the title of most liquid asset. Moreover, assets like real estate, fine art, and collectibles are considered to be relatively less liquid assets. So, to calculate the overall transformation of an asset into cash takes place by the method of liquidity ratios. This method is popular among marketers as it allows them to estimate revenue of the business more accurately.

Thus, liquidity is a significant player in the study of economics as it plays a crucial role in almost every topic of the subject. While studying the discipline of economics, you will go through this term multiple times as you realise the significance of liquidity. The flow of liquidity in the market should be controlled efficiently for the sustainable development of an economy. If you want to attain a better understanding of liquidity, you can refer to the below example:

Are you familiar with the Bank of England's recent move in scrutinising lenders capacity? The Bank of England is planning to keep an eye on the ability of lenders to withstand a severe dislocation. It is assumed that the financial markets prompted by a cliff-edge Brexit can be the reason for disruption. According to Sam Woods, chief executive of the BoE's Prudential Regulation Authority, "the boosting bank liquidity was just one measure the body took to reduce risks in the sector. It can boost the UK crash out of the EU in March without a withdrawal agreement or transition period."

Principles of Liquidity Management

4 Principles to Manage Liquidity Effectively

Below are the four most crucial principles of rigid liquidity management that need to be practised in the modern economy:

  • Identify Liquidity Risks Early

There are system-wide consequences faced by a branch or institution if it lacks liquidity. So, it is predominant for your bank to be financially prepared in case of a shortfall occurs. This calls for a robust method for identifying and measuring liquidity risk to prevent any worst case scenario.

  • Monitor and Control Liquidity Regularly

It is crucial to actively monitor and control any risk exposures or funding needs once you have identified your bank's liquidity risk. Also, you need to keep track of multiple legal entities, business lines, and international currencies depending on the strength of your bank.

  • Conduct Scheduled Stress Tests

To ensure the sustainability of your bank, you need to conduct financial stress tests regularly to predict and prevent various liquidity shortfalls. Doing tests like these is similar to those fire drills or emergency drills conducted in colleges or corporates. Therefore, to eliminate every possible risk, you need to test your bank on every parameter including both short-term and long-term scenarios.

  • Create A Contingency Plan

To stand against the worst-case scenario, you must have a successful contingency plan in case your primary idea does not work. To prepare effective strategies, you need to understand the policies to develop a formal contingency funding plan (CFP). It can help you to overcome unexpected liquidity shortfalls in various emergencies.

Importance of Liquidity Management

It is imperative to manage the rate of cash flowing in the market to ensure the sustainable development of an economy. So, it created a demand to propose a system to monitor the liquidity rate successfully and even take the necessary steps to control it. It is crucial as liquidity plays a significant role in influencing the economy either positively or negatively.

Why is Liquidity Risk Significant?

With the developing era, the need for the most advanced banking system also emerged to prevent the possible financial crisis. Thus, banks and capital market firms need to improvise to manage liquidity in the economy. The financial ecosystem and global economy get affected as the outcome of poor liquidity risk management system.

Moreover, to ensure a better future in terms of economics, it is imperative for the responsible authorities to do their part sincerely. The financial institutions are also contributing to this idea by upgrading their liquidity risk management system for the good of the economy. There are still banks out there having poor liquidity management adding to their increasing problems with the liquidity crisis.

Why liquidity is vital in property holdings?

Property holdings or holding collateral is an old practise used by the banks since a very long time. While practising this, banks provide a certain sum of money as a loan either to an individual or an organisation. But, the interesting fact about this is that, before getting the money, an individual needs to submit something to the bank as collateral. The value of collateral that a bank holds is almost equivalent to the amount of money it lends. This is because, in the case of insolvency or bankruptcy, the bank can sell that collateral to balance for their loss. Therefore, investors need to realise the significance of liquidity if they want to get in and out without any delays.

Liquidity Risk Management in Banks

The failure of a bank to meet indebtedness without affecting the bank's financial condition adversely is the liquidity risk. Therefore, an effective risk management programme helps to enhance the bank's capability to reduce the probability of adversities.

How do you calculate liquidity?

The basic formula to calculate liquidity can be given as follows:

Liquidity = Assets / Liabilities

What is the Liquidity Ratio?

It is the type of ratio revealing one's ability to pay its debt before the due date. So, this ratio educates us on the rate of a company to convert its assets into cash to pay off its liabilities. Liquidity ratio is a short-term solvency method used to pay off the debts on a timely basis.

The Relationship between Liquidity and Profitability

The fundamental relationship between liquidity and profitability is net profit gain. The net profit gained by an organisation is the only factor that plays a significant role in the calculation of both liquidity and profitability.

Books On Liquidity

Book 1

Market Liquidity: Theory, Evidence, and Policy

Published by Oxford University Press in 2013

By Thierry Foucault, Marco Pagano, Ailsa Roell (Authors)

Book 2

Market Liquidity: Asset Pricing, Risk, and Crises

Published by Cambridge University Press in 2012

By Yakov Amihud, Haim Mendelson, Lasse Heje Pedersen (Authors)

Book 3

Market Liquidity: Theory, Evidence, and Policy

Published by Oxford University Press in 2013

By Thierry Foucault, Marco Pagano, Ailsa Roell (Authors)

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Liquidity

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