wealtheducation-what_is

What is Liquidity?

Liquidity in simple terms is how fast can an asset be transform into cash.

For example a bank lends money to homeowners so that they could own their homes. But in return these homeowners are asked to pay back the principal amount with interest for an agreed number of years while the property is being collaterialized by the bank. If these homeowners default on their loan repayments, the banks will move to covert these collaterialized homes or assets into cash by selling them into the open market. The question is how fast can they sell them and convert these assets into cash?

Another example is a stock investor who buys a particular stock and in one month's time he needs cash urgently and decides to sell it into the open market, again how fast can he convert his stock assets into cash?

That is what liquidity is all about.

There are basically 3 kinds of liquidity:

1) Macroeconomic liquidity, which has to do with “overall monetary conditions,” including interest rates, credit conditions, and the growth of monetary and credit aggregates.

2) Market liquidity, which refers to how readily one can buy or sell a financial asset without causing a significant movement in its price. Like the 2 examples stated at the top.

3) Balance sheet liquidity, which refers broadly to the cash-like assets on the balance sheet of a firm (or household). For non-financial firms, balance sheet liquidity is often measured by the short-term liquid assets on their balance sheet. For banks, which must manage their liquidity very closely, balance sheet liquidity is reflected in a detailed breakdown, by maturity, of their assets and liabilities – especially those coming due in the short term. The ability of banks to fund themselves is often referred to as funding liquidity.