Liquidity refers to an entity’s ability to meet its current obligations. Therefore, liquidity is a relative concept having to do with size, frequency, and relationships of liabilities due; and with current assets that presumably provide the source of funds to meet such obligations.
By contrast, solvency talks of an entity’s ability to meet interest cost, repayment schedules, and other obligations in the longer term. The most important elements in judging a company’s solvency are: “Debt capital” and “Equity capital“:
- Debit capital is a different name for liabilities, particularly those of the medium to longer term. Failure to meet debt capital requirements usually leads creditors to taking legal action, which may force the entity to bankruptcy.
- Equity capital is much less risky to the firm, because shareholders receive dividends only at the discretion of the board.
Theoretically, liquidity and solvency are different notions, but practically, under certain conditions they merge [as Dr Gerry Corrigan, The chairman of the New York Fed, pointed out to Dr Alan Greenspan in September 1987].
As far as both liquidity and solvency are concerned, companies must be able to meet their obligations when they fall due. In commercial banking, for example, such obligations mainly comprise deposits at sight or short notice, term deposits, bought money as well as commitments to lend, including unutilized overdraft facilities, and commitments due to derivatives losses.
In any period of time, existing obligations and their incidence vary between different entities, but the maintenance of an assured capacity to meet them is an essential principle of sound governance which is common to all firms. The responsibility of assuring liquidity and solvency lies with the board, CEO, and senior management. For liquidity reasons, the company must hold sufficient immediately available cash or liquefiable assets subject to:
- The provision that marketable assets vary in quality and in terms, and
- The estimation of the prices at which such marketable assets are capable of being sold is subject to uncertainty.
Senior management must also be able to secure an appropriately matching future profile of cash flows from maturing assets, always accounting for shortfalls if borrowers are unable to repay. While shortfalls can lead to serious problems, abundant liquidity that is unwanted results in lower profits. Sometimes abundant liquidity is the result of management’s failure to closely watch appropriate liquidity ratios. In other cases, it is a symptom of the attraction presented by cash and interest-bearing money.
Notes: High liquidity may also represent deferred spending, or it may be needed to supplement falling income.
In the banking industry, for example, a valid liquidity strategy is that of maintaining an adequately diversified deposit base in terms of both maturities and type of counterparties. Depending on the individual counterparty’s standing, and on the general liquidity situation in the financial system, this might add up to a hedging policy that can provide the ability to raise fresh funds without undue cost.
Classical measures of liquidity have involved a comparison of deposit liabilities, in part or in total, with the available stock of certain assets generally accepted to be liquid. The benefit from this approach is simplicity, but the classical method:
- does not account for factors that are non-traditional, such as derivative financial instruments;
- does not reflect the fact that many accounts are not sharply liquid or non-liquid, but have tonalities of grey; and
- does not benefit from the development of asset and liability management techniques, for controlling liquidity through cash flows.
Neither are legacy methods for liquidity management accounting for a bank’s creditworthiness as perceived by depositors, its position in the system of credit institutions, or the current financial conditions. Analyses that differentiate for these issues are more in touch with the real underlying liquidity condition.
Another example where a more analytical approach is advantageous is when distinctions are drawn between different types of deposits, for example between retail and wholesale deposits – and within retail demand between deposits and savings, including constraints associated to withdrawals from savings accounts. The stability and diversification of the deposit base should always be given due weight.
Additionally, known firm commitments to make funds available on a particular date must be incorporated in the appropriate time band at their full value. Liabilities should include any significant non-deposit commitments, which mature within the time span of the measurement, such as tax liabilities. Assets, too, should be measured by reference to their maturity and fair value.
Within the perspective of a liquidity study, the treatment of marketable assets must take account of the extent to which they can be sold quickly for cash, or used as security for borrowing. Quick liquefication means no fire sale, but quite the opposite: incurring little or no cost penalty.
Credit risk and market risk, which may impact on the assets’ potential value, should also be accounted for. It is important to assure that the market for the asset is sufficient and there is stable demand for it. An important factor in fair valuation is the willingness of the central bank to use the assets in its normal market operations.
Different considerations affecting asset value are recognized in calculation of net worth and cash flows by applying varying discounts, normally against the market value of marketable assets. Assets known to be of doubtful value must be excluded from the general liquidity measurement, being treated on a case-by-case basis with considerable discount. In the general case, the further ahead a bank’s assets mature, the more difficult it is to estimate confidently credit, market, and other risks which will characterize them at maturity.
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