What Is a Liquidity Gap?

Liquidity gap is a term used in several types of financial situations to describe a discrepancy or mismatch in the supply or demand for a security or the maturity dates of securities. Banks deal with liquidity risks and potential liquidity gaps to the extent that they need to make sure they have enough cash on hand at all times to meet requests for funds.

When the maturity of assets and liabilities differ, or there is higher than expected demand for funds, the bank might experience a shortage of cash and, therefore, a liquidity gap.

Key Takeaways

  • A liquidity gap in the financial world refers to when there is a mismatch in the supply or demand for a security or the maturity dates of securities.
  • Banks need to manage possible liquidity gaps to ensure that they are able to meet client deposit withdrawals at all times and not have too many deposits loaned out.
  • A liquidity gap can also occur when a company does not have enough cash on hand to meet operational needs.
  • To compare periods of time, banks calculate the marginal gap, which is the difference between gaps of different periods.
  • During the financial crisis of 2008, many investors found themselves unable to sell securities as there were no investors willing to buy securities at depressed prices, causing a lack of liquidity in many securities.

Understanding a Liquidity Gap

A firm might also experience a liquidity gap when they don't have enough cash on hand to meet operational needs and have assets and liabilities maturing at different times. Liquidity gaps can also occur in the markets when there is an insufficient number of investors to take the opposite side of a trade, and people who are looking to sell their securities are unable to do so.

For banks, the liquidity gap can change over the course of a day as deposits and withdrawals are made. This means that the liquidity gap is more of a quick snapshot of a firm's risk, rather than a figure that can be worked over for a long period of time. To compare periods of time, banks calculate the marginal gap, which is the difference between gaps of different periods.

During the early months of the global financial crisis, some bond and structured product investors found they could not sell their investments. There was a liquidity gap in that there weren't parties that were willing to take the other side of the trade and purchase the securities at depressed prices. This lack of liquidity caused markets in some securities to dry up for several weeks.

Example of a Liquidity Gap

Hedge Fund ABC purchases $100 million worth of mortgage-backed securities (MBS) in February as the outlook of the housing market is strong and it believes that the assets it purchased will provide a steady stream of income for the foreseeable future. ABC also believes that if it ever needs to sell its MBSs then it will have no problem doing so because liquidity in the market is high, with a significant amount of traded volume, with many buyers and sellers transacting on a daily basis.

As the year progresses, the economy takes a downturn due to an intense hurricane season destroying crops and many important shipping ports. This in turn causes significant job losses. Due to the job losses, many laid-off individuals are not able to pay their mortgages on time, causing defaults on their home loans.

Banks use a person's liquidity gap to determine the interest rate they will charge on a loan. If the liquidity gap is negative, a bank will not issue a loan or will charge a high interest rate.

Because no payments are being made on these home loans, which are the underlying assets of the MBSs, the MBSs start defaulting, meaning no income stream is coming in. This causes the value of these MBSs to fall. Hedge Fund ABC decides to sell its portfolio of MBSs, which is now valued at $70 million rather than $100 million, resulting in a loss of $30 million.

However, ABC is only able to sell off $20 million of its portfolio and cannot find buyers for the remainder of its MBS portfolio. It tries to sell the portfolio at a discount, however, buyers are not interested because the housing market is in a free fall and no one knows how low it will go and if the value of the MBS portfolio will fall further. Hedge Fund ABC is experiencing a liquidity gap where it has a portfolio of assets to sell but no buyers to sell it to.

What Kinds of Situations Might Arise in Which a Liquidity Gap Is Necessary?

There are no particular situations in which a liquidity gap is necessary. Having more assets than liabilities is always a better situation as it allows for flexibility, growth, and an overall comfortable financial position. In some cases, if a company is new and growing, and they are pouring all resources into growth, leaving little in liquid assets, thus requiring them to borrow money to fund any liquidity gaps, it could be seen as acceptable as the discrepancy is being managed and used for growth.

How Is a Liquidity Gap Calculated?

A liquidity gap is calculated as assets minus liabilities. For a company, this would be all assets, such as cash and marketable securities, and all liabilities, such as short-term debt. Depending on the calculation, the numbers can either focus on liquid assets and short-term liabilities or all assets and liabilities.

What Does Negative Liquidity Mean?

Negative liquidity is when liabilities outstrip assets, meaning that a company does not have enough assets to cover its obligations. The company has liquidity risk in this case.