Liquidity measures the ease of converting assets into cash. While stocks and bonds are relatively easy to liquidate, cash is the most liquid asset.
Most liquid assets held by banks are in the form of cash deposits. This is determined by supply and demand for central bank money. Having enough money in a financial system not only drives decision-making at a macroeconomic level, but also at a microeconomic level. This demand and supply influences interest rates, which then have an effect on spending decisions, loan applications and investments.
Liquidity in the financial system is important because it gives consumers in any market more choice.
It may also refer to these ease with which institutions can borrow or take on leverage. If an organisation is applying for finance, the level of liquidity will be a major factor the decision to grant credit or not.
For any business operation, liquidity should be a key part of long-term strategies. It’s for this reason that the management of liquidity risk should be managed. Any liquidity framework that is built by organisations should be able to withstand all kinds of stress. It’s also important to constantly assess it. This may involve the use of ratios in order to work out how liquid a company is. An acid test ratio will provide the best insight in this case.
If stock exchanges close, investors lose access to cash and investments. For investors, a portion of their wealth should be kept in the form of liquid assets to survive emergencies.
Liquidity in the financial system must be monitored and maintained at a particular level for the benefit of an economy.