A company's liquid assets can easily be converted into cash to meet financial obligations on short notice. Liquidity is the ability of a business to pay its debts using its liquid assets.

The most common types of liquid assets for all businesses, from banks to electronics manufacturers, are funds in checking and savings accounts, and marketable securities, such as stocks and bonds. Highly liquid securities can be bought and sold quickly and easily without affecting their price. Liquidating a stock investment is as simple as placing an order, which almost instantly triggers the sale of shares at the current market price.

A bank's liquidity is determined by its ability to meet all its anticipated expenses, such as funding loans or making payments on debt, using only liquid assets. Ideally, a bank should maintain a level of liquidity that also allows it to meet any unexpected expenses without having to liquidate other assets. The bigger the cushion of liquid assets relative to anticipated liabilities, the greater the bank's liquidity.

To understand the importance of liquidity to a bank's continued solvency, it helps to understand the difference between liquid and illiquid, or fixed, assets. Illiquid assets cannot swiftly be turned into cash, including real estate and equipment that provide long-term value to the business. Using illiquid assets to meet financial obligations is not ideal. Selling off real estate to meet financial obligations, for example, is inefficient and potentially expensive. If funds are needed in a hurry, the company may have to sell the property at a discount to expedite the liquidation.

In addition, liquidating these types of assets to pay debts can have a detrimental impact on a business's ability to function and generate profit down the road. A clothing manufacturer that has to sell its equipment to pay off loans will have difficulty maintaining consistent production levels and will likely need to take on new debt to purchase replacements. Liquidating fixed assets is a last-resort solution to a short-term problem that can have devastating long-term consequences.

During the financial crisis of 2008, it became clear that banks were not maintaining the stores of liquid assets necessary to meet their obligations. Many banks suffered the sudden withdrawal of depositor funds or were left holding billions of dollars in unpaid loans due to the subprime mortgage crisis. Without a sufficient cushion of liquid assets to carry them through troubled times, many banks rapidly became insolvent. In the end, the banking industry was in such a poor state that the government had to step in to prevent a total economic collapse.

The liquidity coverage ratio rule was developed as a means of ensuring that banks maintain a level of liquidity sufficient to avoid a repeat performance of 2008. Under the new rule, all banks must maintain liquid asset stores that equal or exceed 100% of their total anticipated expenses for a 30-day period. In the event of a sudden dip in income or an unexpected liability, banks can meet all their financial obligations without having to take on new debt or liquidate fixed assets, giving them time to resolve the issue before it turns into another financial disaster.

  1. Is liquidity calculated by flow?

    Read about the differences between economic liquidity, financial liquidity and asset liquidity and how each respective type ... Read Answer >>
  2. How much liquidity is considered too much liquidity?

    Learn about the risks of holding too much cash or investing in assets that are too liquid, and discover how liquidity is ... Read Answer >>
  3. What's the difference between the coverage ratio and the liquidity coverage ratio?

    Understand the difference between coverage ratios and the liquidity coverage ratio and why the liquidity coverage ratio rule ... Read Answer >>
  4. What are some of the risks of holding liquid assets?

    Find out how the holders of liquid assets assume risks associated with opportunity cost and inflation in exchange for solvency ... Read Answer >>
  5. What is the purpose of liquidation?

    Read about the role of liquidation in corporate finance and why it encourages discipline and efficiency in a market economy. Read Answer >>
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