L

How Liquid Should We Be?

By: Mo Lidsky

Northern Rock stood for over 150 years, was traded on the London Stock Exchange, was one of the United Kingdom’s largest retail banks, accounting for as much as 10% of all British market home mortgages. Then, on one fall day in 2007, it collapsed. With fears about the solvency of the bank and the poor quality of its mortgages, Northern Rock approached the British government for help with liquidity. Within 24 hours the news broke that the bank approached the government for help. Concerned that their savings were at risk, the public reacted with a striking lack of confidence and thousands of people descended on bank branches across Europe. All of them demanded the immediate receipt of their money. The run on the bank precipitated its collapse, forcing the government to take possession and nationalize what was left of it.

While this sounds like a totally wild scenario, it wasn’t isolated. Similar stories played out with Bear Stearns, Lehman Brothers, Wachovia, and others. The problem in all cases was liquidity. Liquidity is central to the financial system because banks essentially take liquid assets (deposits) and convert them into illiquid assets (loans), trying their darndest to manage liquidity such that the equilibrium between depositors and borrowers can be maintained.  In many ways, this isn’t too different from what any investor does when matching personal liquid assets to impending liabilities and matching illiquid assets to far-off potential liabilities.

To ensure that people don’t run into a difficult situation, there must be a reasonably good understanding of what “liquidity” actually is.

What is liquidity?

Liquidity is simply the speed at which assets can be converted into useable cash with little to no loss in value. In other words, it is the ability to buy or sell assets without affecting the price and having price transparency on those assets along the way.  In the absence of liquidity, there is a potential domino effect of negative events – such as we are witnessing today.

People who may have significant assets, but with insufficient liquidity, suddenly find themselves in need of cash. To shore up liquidity, they are forced to sell some assets (often assets they didn’t plan on selling). Since these fire sales often happen in clusters (e.g. everyone needs money in a crisis) they lead to significant price dislocations, whereby assets are sold at significant discounts due to inefficient price discovery, higher trading costs, etc. These lower prices tend to scare markets and financial institutions, which lead to margins calls (where significant leverage is employed). Margin calls lead to either more fire asset sales or debt defaults that affect the creditworthiness of all parties. Poor creditworthiness reduces confidence and leads to weaker prospects for future wealth creation. And we are seeing this ugly scenario beginning to play out in the markets today.

The interesting thing about liquidity is that most people don’t generally worry about it until it’s too late.  They don’t worry about it because they confuse solvency with liquidity, which is not one and the same. One can have great assets, but with no liquidity, great assets would need to be sold at a bad price – e.g. if you owe someone money, and there’s nothing in your wallet, they’re taking your expensive watch. Therefore, it’s important to remember that as a result of liquidity issues, perfectly solvent people, businesses, or institutions can still go bust.

People also forget that there are three unique forms of liquidity that need to be managed.

  • Systemic liquidity can be loosely thought of as the smooth functioning of the banking system that can be used to settle intra-bank payments, cover payroll, ensure ATMs don’t run dry, etc. Since most people don’t have their cash sitting under their mattress or in a homesafe, rather, in a bank account, every asset owner is exposed to systemic concerns. This is often referred to as counterparty risk. We are reliant on the “institutions” holding our capital, reliant on the institutions managing the exchange rates of global currencies, and so on.
  • Transactional liquidity is the ease with which market participants can buy and sell financial assets. This is less about infrastructure and more about the participants. Some assets are easier to sell, some markets are deeper, some people are more risk-oriented. The transactional liquidity of assets is usually proxied by bid-ask spreads, volatility, market depth, risk appetite, and the regulatory environment. It is also often dictated by fear and greed. Transactional liquidity is less driven by facts and more driven by the psychology of the market.
  • Credit liquidity is the ability of borrowers to access credit, whether that involves increasing debt by rolling over existing loans or accessing new bank loans, bond issuance, trade finance, etc. Credit liquidity is a function of risk appetite, not bank reserves, and is affected by a combination of systemic and transactional factors that keep the engine of credit creation running.

In a nutshell, liquidity is defined by how quickly you could access your money (Systemic), how quickly you could sell your assets (Transactional), and how efficiently you could borrow (Credit).

One might think that liquidity is one-sided, but there is also considerable benefit from illiquidity, as there is a very clear correlation between an asset’s liquidity and its return. Generally, the less liquid an asset the higher its potential for return. For example, bonds with higher duration (longer maturity and less liquidity) offer a bigger coupon. The same is true for small-cap vs. large-cap equities, for private vs. public equities, for private real estate vs. publicly-traded REITs, and so on.

So, how should families be thinking about liquidity?

There are generally four ways that private investors and families should be determining what is the right amount of liquidity for them.

  • Practical considerations. Having enough liquidity to cover several years of living expenses and all anticipated purchases
  • Investment considerations. Having enough liquidity to cover capital calls, liability coverage and/or reinvestment needs
  • Rainy day considerations. Having enough liquidity to cover estate tax liabilities in case of untimely death, unexpected lawsuits, etc.
  • Opportunistic considerations. Having some liquidity to take advantage of macroeconomic conditions and opportunities when no one else has the capital

In summary, investors and families need to manage their liquidity as thoughtfully and strategically as they manage their asset allocation, balancing the different liquidities, the benefits that illiquidity provides, and the various considerations of their individual circumstances.

Media Contact

For any media questions or requests, please email

‍Please note: this email address is only for media inquiries, and only inquiries from the media will receive a response. For all other questions, please select a category from our Contact Us page.

More Resources

Loading...
en_USEnglish