Liquidity – finance for everyone

In the plural, liquidity refers to cash assets and, in a broader sense, assets that are available at any time. In the singular, the term liquidity refers to the fact that an asset can be bought or sold quickly. Liquidity is usually understood as the risk of being deprived of it.

One of the primary characteristics of an investment, apart from its profitability and low exposure to risk, is its liquidity. So the more liquid the market, the easier, faster and cheaper it is to transact there (buying or selling) important.

When it comes to financial assets (shares, bonds), liquidity is mainly made possible by listing on the stock exchange. It’s even basic functions of the stock market thus guaranteeing savers that they will be able to resell their securities. The values ​​of multinational companies are more liquid than the values ​​of small companies that operate in a narrower market.

All markets are affected

Liquidity concept applies to all markets (real estate, financial, short-term, long-term credit). A liquidity problem in one market can spill over into another. Therefore, if an investor urgently needs money and cannot sell one of his assets, he can switch to another, more liquid asset in his portfolio that he would not otherwise sell.

Consider the example of an individual who is faced with an unexpected expense that must be financed in less than a month. In addition, he would like to sell a second house located in a sparsely populated region. However, the low number of buyers and the length of the property sale procedure do not allow this. He was then forced to sell his stock or liquidate his life insurance, which was not his preferred option.

PUSH bank liquidity translated by the bank’s ability to meet its cash obligations as they mature. This capacity is monitored like milk on fire by banking supervisors, who have put in place various rules and ratios to ensure that banks manage their liquidity risk as best as possible.

For banks that are more concerned with asset trading, bank liquidity represents the bank’s ability to “liquidate” (sell) a non-monetary asset (eg an investment security) in the markets. Then we talk about “market liquidity”.

Securitization to increase liquidity?

This transmission phenomenon is even more true today due to the sophistication and globalization of financial products that allow recourse to the securitization of illiquid assets. Securitization makes it possible to group more or less heterogeneous assets into a security listed on the market, on which financial institutions undertake to offer a purchase and sale price. However, what is gained by these financial innovations in terms of liquidity for the investor is lost in the transparency of the quality of the assets contained in them. He is therefore unable to form an accurate idea of ​​the risk he has taken. Liquidity risk is borne by the financial institution that undertakes to immediately provide money to the selling investors. They then take on the responsibility of finding a new buyer with the risk, if they don’t find one, of ending up with illiquid assets that they have to hold until maturity.

Liquidity problems

Markets can become illiquid due to severe imbalances between supply and demand. If supply decreases, prices rise. Conversely, if the asset is no longer in demand, the seller is required to agree to a significant reduction in order to find a buyer. In some cases, the price is not even formed.

This is what happened in the crisis subprime from 2008, when investors realized that some of the assets that were securitized were of worse quality than they thought. They were all trying to sell at the same time.

Liquidity was then no longer provided by financial institutions or at a price so low as to discourage sales. There were no buyers for many sellers. The market became illiquid, forcing investors to sell assets in other, more liquid markets (such as stocks).

We also noticed serious problems with liquidity in the market of short-term loans that banks create among themselves (interbank market). Every financial institution began to fear that its competitors would run out of liquidity to meet their obligations and then be forced to declare bankruptcy (which was the case with Lehman Brothers).

Central banks had to step in to provide liquidity to banks, which gives them huge credit. What followed showed that this liquidity crisis has quite deep roots (the US real estate bubble) and therefore will not be resolved very quickly…

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