1.1 Background to the Study
Cash liquidity reflects a financial institution’s ability to fund assets and meet financial obligations. Cash liquidity is essential in all banks to meet customer withdrawals, compensate for balance sheet fluctuations, and provide funds for growth. Funds management involves estimating liquidity requirements and meeting those needs in a cost-effective way. Effective funds management requires financial institutions to estimate and plan for cash liquidity demands over various periods and to consider how funding requirements may evolve under various scenarios, including adverse conditions.
Banks must maintain sufficient levels of cash, liquid assets, and prospective borrowing lines to meet expected and contingent liquidity demands. Liquidity risk reflects the possibility an institution will be unable to obtain funds, such as customer deposits or borrowed funds, at a reasonable price or within a necessary period to meet its financial obligations. Failure to adequately manage cash liquidity risk can quickly result in negative consequences for an institution despite strong capital and profitability levels. Management must maintain sound policies and procedures to effectively measure, monitor, and control liquidity risks.
In business, economics or investment, market liquidity is a market’s ability to purchase or sell an asset without causing drastic change in the asset’s price. Equivalently, an asset’s market liquidity (or simply “an asset’s liquidity”) describes the asset’s ability to sell quickly without having to reduce its price to a significant degree. Cash liquidity is about how big the trade-off is between the speed of the sale and the price it can be sold for. In a liquid market, the trade-off is mild: selling quickly will not reduce the price much. In a relatively illiquid market, selling it quickly will require cutting its price by some amount.
Money, or cash, is the most liquid asset, because it can be “sold” forgoods and services instantly with no loss of value. There is no wait for a suitable buyer of the cash. There is no trade-off between speed and value. It can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs. If an asset is moderately (or very) liquid, it has moderate (or high) liquidity. In an alternative definition,liquidity can mean the amount of cash and cash equivalents. If a business has moderate cash liquidity, it has a moderate amount of very liquid assets. If a business has sufficient liquidity, it has a sufficient amount of very liquid assets and the ability to meet its payment obligations.
An act of exchanging a less liquid asset for a more liquid asset is calledliquidation. Often liquidation is trading the less liquid asset for cash, also known as selling it. An asset’s liquidity can change. For the same asset, its liquidity can change through time or between different markets, such as in different countries. The change in the asset’s liquidity is just based on the market liquidity for the asset at the particular time or in the particular country, etc. The liquidity of a product can be measured as how often it is bought and sold.