What is a Liquidity Cushion
- Liquidity refers to the cash assets a company or individual has on hand. Assets that are not cash and hard to turn into cash quickly are illiquid.
- Cash in reserve is a hedge against external shocks to an individual or company's operating expenses.
- A company or individual's operating expenses, their obligations (like debt payments) versus their income, may have a thin margin. When this is the case, having a liquidity cushion means they won't have to sell illiquid assets to cover expenses if there is a shortfall in income.
A liquidity cushion of cash reserves or money market instruments can prevent a company from having to sell more illiquid securities or other investments – possibly at a loss – to raise cash to meet short-term obligations like repaying loans, bills or wages. A liquidity cushion is sometimes called a "rainy day fund."
How a Liquidity Cushion Works
A liquidity cushion protects an individual or a business from having to sell illiquid assets like real estate or equipment to pay off debts.
The same principle applies to banks and other financial institutions that buy and sell assets by borrowing money, also known as trading using leverage. If a company or trader is too highly leveraged and they don't have a liquidity cushion or cash reserve, they can be forced to sell assets at a loss if they can't dip into cash reserves to service debt obligations.
The opposite of a liquidity cushion is a liquidity crunch, where an individual or a company finds it does not have the cash on hand to pay their obligations by the due date. In finance, when banks do not have the cash to cover depositors' demands for money, it's called a liquidity crisis.
Real-Life Examples of a Liquidity Cushion
Automobile companies, for example, are wise to keep a bit of a cash buffer, given that their industry is so cyclical. The Ford Motor Company, for example, having long understood that financial health is key to its success, mortgaged all the company’s assets for $23.6 billion in loans in November 2006, to finance an overhaul and give it a cushion to protect itself against a recession.
This shrewd move was to prove Ford’s salvation. Unlike General Motors and Chrysler, it did not need to be bailed out by the government during the global financial crisis. Nor did Ford have to give any concessions to union workers as a condition for Federal aid. Moreover, its self-sufficiency also turned into a valuable marketing tool.
Ford is quite a highly leveraged company, and while it could do more to cushion itself against another recession, it has $31 billion in cash set aside for a rainy day (current as of Q2 2020).
Similarly, The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) requires banks to have a liquidity cushion in case of another financial crisis similar to the financial crisis of 2008. According to the Federal Housing Finance Agency, "The Dodd-Frank Act requires certain financial companies with total consolidated assets of more than $250 billion, and which are regulated by a primary federal financial regulatory agency, to conduct annual stress tests to determine whether the companies have sufficient capital to absorb losses and support operations during adverse economic conditions."