Liquidity management takes one of two forms based on the definition of liquidity. One type of liquidity refers to the ability to trade an asset, such as a stock or bond, at its current price. The other definition of liquidity applies to large organizations, such as financial institutions. Banks are often evaluated on their liquidity, or their ability to meet cash and collateral obligations without incurring substantial losses. In either case, liquidity management describes the effort of investors or managers to reduce liquidity risk exposure.
Liquidity Management in Business
Investors, lenders, and managers all look to a company's financial statements using liquidity measurement ratios to evaluate liquidity risk. This is usually done by comparing liquid assets and short-term liabilities, determining if the company can make excess investments, pay out bonuses or, meet their debt obligations. Companies that are over-leveraged must take steps to reduce the gap between their cash on hand and their debt obligations. When companies are over-leveraged, their liquidity risk is much higher because they have fewer assets to move around.
All companies and governments that have debt obligations face liquidity risk, but the liquidity of major banks is especially scrutinized. These organizations are subjected to heavy regulation and stress tests to assess their liquidity management because they are considered economically vital institutions. Here, liquidity risk management uses accounting techniques to assess the need for cash or collateral to meet financial obligations. The Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010 raised these requirements much higher than they were before the 2008 Financial Crisis. Banks are now required to have a much higher amount of liquidity, which in turn lowers their liquidity risk.
Liquidity Management in Investing
Investors still use liquidity ratios to evaluate the value of a company's stocks or bonds, but they also care about a different kind of liquidity management. Those who trade assets on the stock market cannot just buy or sell any asset at any time; the buyers need a seller, and the sellers need a buyer.
When a buyer cannot find a seller at the current price, he or she must usually raise his or her bid to entice someone to part with the asset. The opposite is true for sellers, who must reduce their ask prices to entice buyers. Assets that cannot be exchanged at a current price are considered illiquid. Having the power of a major firm who trades in large stock volumes increases liquidity risk, as it is much easier to unload (sell) 15 shares of a stock than it is to unload 150,000 shares. Institutional investors tend to make bets on companies that will always have buyers in case they want to sell, thus managing their liquidity concerns.
Investors and traders manage liquidity risk by not leaving too much of their portfolios in illiquid markets. In general, high-volume traders, in particular, want highly liquid markets, such as the forex currency market or commodity markets with high trading volumes like crude oil and gold. Smaller companies and emerging tech will not have the type of volume traders need to feel comfortable executing a buy order.