Liquidity is the ability of a particular asset to be changed into cash immediately and with no price discount. It also refers to the investor’s capability to alter an asset into hard cash. The quicker the conversion will be, the more “liquid” the asset. As an opposite, illiquidity is one risk whereby an investor would not be able to alter or change the asset in hard cash when it is most needed. What is more, is when having to remain for the selling of the asset may pose additional risks if and when the price of such asset would decrease while coming up in order to liquidate.
When we speak of investments, business or economics, market liquidity is considered as an asset’s capability to be place on the market absent any causing of significant movements on the value and with the least amount of value. Cash on hand or money is the most “liquid” asset which can be used without delay in order to perform profitable actions, such as, selling, buying, paying debts and/or meeting the immediate needs and wants.
An action of exchange of a smaller amount of liquid asset within a more “liquid” asset is commonly called as liquidation, since liquidity is also prefers on both business’s capability to meet-up with its payment responsibilities, in some terms of owning enough liquid assets and such assets themselves.
In the world of banking, liquidity is referred to as the capability to encounter the obligations whenever they become due and demandable absent any incurring of unacceptable losses. The act of managing liquidity is an everyday procedure which requires bank personnel to check and project the cash flow ensuring that the adequate liquidity is maintained and preserved. For maintaining a balance level of both the short-term liabilities and the short-term assets is exactly critical.
For a particular banking institute, the client’s deposits are always the primary liabilities, in sense that banks are meant to present back all the deposits that a certain client had on demand. While loans and reserves are the primary assets, in sense that such loans are owed to the bank and not by themselves. The investment selection represents smaller fraction of assets which will serve as a primary resource of liquidity. The investment securities may be liquidated in order to satisfy the increased loan demand and the deposit withdrawals. Banking institutions can have various additional options intended for generating liquidity, like borrowing from other banking institutions, selling loans, borrowing from central bank, like the United States “Federal Reserve Bank” and increasing additional capital.
In a most terrible case, depositors can demand their finds whenever the bank is not capable to generate sufficient cash absent the incurring of substantial financial shortfalls. In some severe circumstances, this can result in a “bank run”. Most of the banking institutions are subjected to legally mandated requisites designed for helping banks to avoid liquidity crisis.
And so, as much as liquidity is desired for the reason that bank deposits are being insured by the government in mostly developed countries. Lack of liquidity may be remedied for by increasing deposit rates and marketing effectively deposit products.