What is liquidity? Basic information about liquidity you should know

Liquidity it is the ability to convert to the cash of an asset or a product.

What is liquidity?

Liquidity is a concept in the financial sector. Liquidity refers to the degree of fluidity (or liquidity) of any product / asset that can be bought or sold in the market without its market price being affected. influence much.

In general liquidity is a term used to refer to the ability to convert into cash of an asset or a product.

Cash, for example, is the most liquid asset because it can be used to “sell” (in exchange for goods / services) with virtually unchanged value. Other assets such as real estate, factories, machines … have lower liquidity because it takes a very long time to convert these assets into cash.

Meaning of liquidity

Liquidity shows the flexibility and security of an asset / market:

Short-term / liquid assets are highly liquid when their prices are less volatile in the market.

The more dynamic and efficient a market operates, the higher liquidity is

Asset classification by liquidity

In accounting, short-term / liquid assets are sorted by high to low liquidity as follows:

1. Cash,

2. Short-term investments

3. Receivables

4. Short-term advances

5. Inventory.

Cash has the highest liquidity because it can always be used directly for payment, circulation and storage.

Inventories have the lowest liquidity because they have to go through a stage of distribution and consumption, then turn into a receivable, and then turn into cash for a while.

In addition to the 5 types of assets mentioned above, securities are also a type of liquid assets.

See also: What is speculation? The 8 difference between speculation and investment

Stock’s liquidity

Stock’s liquidity is the ability to convert cash into securities and vice versa.

High liquidity securities are available in the market, so it is easy to buy and resell, and the price is relatively stable over time, with a high possibility to restore the capital invested initially .

The liquidity of stock allows investors / investors to convert them to cash quickly when needed. This makes the stock market more and more attractive to investors. The higher the stock’s liquidity, the more dynamic the market is.

Risk in stock liquidity

Investors and banks are not only concerned with the liquidity of securities, but also consider the possibility of reselling them to recover capital. When it is difficult to find buyers or have to sell at lower prices, the security is not likely to recover. At this time, the investor or the bank will incur financial losses.

In fact, if an investor holds a lot of securities but cannot sell, only knows to suffer daily losses, this is a liquidity risk in securities investment.

Factors affecting stock liquidity

Liquidity has a decisive influence on the “fate” of an enterprise’s securities. Therefore, there are many factors that positively and negatively affect stock liquidity as follows:

The first factor, the financial numbers will reflect the stability of production – business activities and development or not. A large reputable enterprise that does well will have high liquidity and vice versa, the business situation is not good, the liquidity is also low.

Secondly, all production and business activities of the enterprise are subject to and affected by policies – regulations of the State and management agencies. Therefore, liquidity is also affected by this impact.

The third factor affecting domestic securities liquidity is for foreign investors:Philippines law only allows foreign investors to buy 30% of shares of commercial banks. shares listed, are allowed to buy 49% shares of other listed business enterprises. This makes foreign investors are not allowed to buy all the shares they are targeting, so they are forced to choose the most suitable type. Therefore, opportunities for domestic enterprises to approach foreign investors are more limited.

The fourth last factor is investor sentiment. Buying and selling in the market depends much on the time and the needs of investors. When the market is flourishing, investors are also more interested in spending money on buying and selling. When the market is falling, investors will be more confused, reserved and cautious.

Recommended to limit risks

Products such as gold, real estate or insurance … on the market are interrelated with each other. When the market fluctuates, it will affect the stock market comprehensively, causing liquidity risk.

Therefore, when choosing securities for investment, banks or investors should consider the possibility of resale to preserve the original investment capital. This is a way to avoid stock risk, prevent the possibility of not reselling, or devaluation when selling.

Conclusion: To limit securities liquidity risk, investors should find appropriate capital allocation.

Bank liquidity

Bank liquidity is seen as the ability to immediately meet the demand for deposit withdrawal and disbursement of committed credit.

For bank liquidity, depending on the characteristics of the demand, the liquidity period will be short or long term.

Short-term liquidity accounts for the majority, as these are transaction deposits or term deposits, money market mobilization tools …

Long-term borrowing is often temporal, cyclical and created by trends.

Whether short-term or long-term liquidity requires banks to have backup funds.

Bank liquidity is the ability to immediately meet the needs of deposit withdrawal and disbursement of committed credit.

Features of bank liquidity

Bank liquidity has the following characteristics:

• Supply – demand of a bank’s liquidity is rarely in balance with each other at a particular time. Banks have to regularly face and settle either a surplus or a deficit.
• When more capital is retained to be ready to meet the liquidity needs, the lower the bank’s ability to generate profits, and vice versa.
• Solving liquidity issues forces banks to incur actual and potential costs, expenses, including:
  • The cost of paying interest on borrowed funds
  • Transaction costs to find capital
  • The opportunity cost in the form of future profits is lost due to the sale of profitable assets.

Liquidity supply

The sources of liquidity for the bank come from:

• Deposits received
• Fees for the provision of services
• Credits earned
• Sales of active and used properties
• Borrowing from the money market
• The need to create liquidity

Activities that create liquidity demand for banks include:

• Clients withdraw money from their deposits
• Customers request a loan
• Other payments
• Costs to create banking products and services
• Payment of dividends to shareholders

Bank liquidity risk

Liquidity risk is a risk in the financial sector. Liquidity risk occurs when a bank lacks viable short-term funds or assets to meet the needs of depositors and borrowers.

Lack of funding here can be understood in two ways:

• Lack of reserves at the bank.
• Capital cannot be raised immediately.

Simply put, this is the type of risk when the bank is unable to provide the sufficient amount of cash for immediate liquidity; Or provide enough but at a high cost.

This risk occurs in the case of a bank’s insolvency due to failure to convert assets into cash in time or be unable to borrow to meet the requirements of the payment contracts.

Banks borrow too much and then invest, leading to liquidity risk

See also: What is foreign exchange? Basic information you should know

Cause of liquidity risk

The reason for the liquidity risk is usually due to the following factors:

• Banks borrow too much deposits and reserves from individuals and other financial institutions, and then turn them into term investment assets. This leads to an imbalance in terms of time between capital sources and capital use. It is very rare that the cash flow returned from investments is exactly balanced with the cash flow being spent to finance previously raised funds.
• Interest rate changes, especially on deposits, as interest rates rise, some depositors withdraw their capital from banks to invest in places with higher rates of return. In the meantime, borrowers may delay loan requests and actively access lower-interest credits. Thus, the change of interest rates affects both depositors and borrowers, both of which affect the liquidity of the bank.
• Interest rate changes also affect the market value of assets banks can sell to increase the supply of liquidity while directly affecting the cost of borrowing in the money market.

Loss from liquidity risk

When the banks lose their liquidity, they will suffer the following micro-scale losses:

• Must race to mobilize capital to ensure the supply of cash for the liquidity needs, leading to mobilizing capital with high interest rates. As a result, when the deposit interest rate is high, it will force the lending interest rate to be high and difficult to loan.
• When a bank has to pay deposit interest rates but cannot lend, it will obviously make the bank lose money.
• The bank loses its liquidity and fails to meet the demand for withdrawal, leading to a loss of trust of the depositors (including interbank transactions). At the same time, the bank cannot meet the disbursement needs for credit loans.

On the macro scale of the economy, when banks lose liquidity, there will be impacts related to inflation, economic growth, stabilization of social life … as follows:

• Affect investment activities. When the deposit interest rate increases, the money will focus on the bank, making the economy reduce the capital mobilization channel;
• The high interest rate for credit will affect the business operations of the business, it will lead to an increase in prices (increase in inflation), decrease in investment scale, leading to a decrease in economic growth;
• When prices rise, it will affect people’s lives.

Recommended liquidity risk management solution

In order to improve the effectiveness of the liquidity risk management policy, state banks and commercial banks should take practical measures. Eg:

For State Bank:

Need to support liquidity for commercial banks through monetary policy management tools.

• For large commercial banks with many qualified papers, the State Bank supports liquidity through open market operations.
• For small commercial banks that do not have enough valuable papers or are unable to compete in the open market, the State Bank shall provide assistance through the refinancing tool.

This support is very short-term and commercial banks will have to adjust the source structure and use the source accordingly, minimizing the liquidity risk.

For commercial banks:

• Comply with the State Bank’s regulations on prudential ratios in the operations of credit institutions; Avoid chasing profits despite risks
• Review the structure of the portfolio of liabilities and assets accordingly to limit possible risks. Carry out the restructuring of capital mobilization and lending in the market; Restructuring short-term loans with medium-term loans.
• Issuing valuable papers, adjusting loan structure to sensitive and risky sectors such as securities, real estate and consumption.
• Maintain a proportion of reserves (including cash in the bank, deposits with the Central Bank and other highly liquid assets). This helps to maintain the required Central Bank reserves and to deal with cash outflows, allowing the bank to both cope with liquidity risks and have a reasonable income.
• Complete regulations related to capital mobilization and lending at market interest rates. Often there is a situation where customers deposit their money before maturity when the market interest rate rises or when other competitors offer a higher rate. In fact, businesses with due bank loans will not pay back the debt, and they worry about paying off the loan, it will be difficult to borrow back the bank. They are penalized for overdue interest rates because they are still lower than the new lending rates. This has affected the liquidity of the bank.
• Managing term risks well: Term imbalances make banks have difficulty in liquidity. For example, mobilizing medium and long term two years but lending three years medium term will make it difficult for a bank to control its cash outflow and cash inflow.
• Implement risk mitigation measures: Banks pay more attention to the derivative money market to better manage their liabilities and assets. Using effective tools such as the REPO Market is helpful in creating high liquidity for debt securities and an existing asset structure to support liquidity for banks quickly. Forward (forward contract) and Future (futures) tools – are derivative financial instruments to hold interest rates to limit the risk of fluctuations in market rates. SWAP (swap) tool is to help banks restructure their liabilities, assets on their balance sheet, and limit the impact of interest rate risk. term risk.

In general, liquidity and liquidity management require administrators and analysts to be really careful between supply and demand, if they do not understand the nature of the problem, loss of liquidity will cause extremely heavy financial losses. masonry.

All of the above content hope to help you understand what liquidity is and how liquidity is understood. At the same time basic information about the types of liquidity in securities and banking will give you useful value.

See also: Liquidity – Wikipedia