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Home > Cash Flow Management Checklists > Identifying Weak Points in Your Liquidity

Cash Flow Management Checklists

Identifying Weak Points in Your Liquidity


Checklist Description

This checklist describes liquidity, and why it is important for companies. The credit crunch of 2007–08 brought liquidity issues to the fore, especially in the banking sector.

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Definition

The liquidity of an asset is the degree to which it, or a security, can be traded on the market without affecting its price, and how quickly this can be done. Another way of looking at liquidity is to determine how quickly an asset can be converted into cash.

Liquidity became a much-discussed topic during the so-called credit crunch in 2007–08. Following the subprime crisis that started in the United States in 2007, banks all over the world suddenly found themselves unable to borrow money from each other as trust ran out and questions were raised over banks’ creditworthiness. This meant that banks had to rely on their own sources of funding, and those with a lack of liquidity suffered. Those that were unable to turn their assets into cash had problems trading.

As a result of the credit crunch, banks had to put new measures in place to identify the weak points in their liquidity. There are companies specializing in liquidity risk management that can help firms to understand and manage their liquidity. A liquidity health check generally involves undertaking a review of processes, systems, and financial reports throughout the company.

When markets are in good health, liquidity is not generally a problem. Liquidity issues tend to become exposed during an economic downturn or recession.

Having liquidity means having the ability to meet obligations as they become due. Liquidity is crucial to the viability, and credibility, of any bank. Even a whiff of a rumor of illiquidity can be enough to trigger a run on a bank—for example, the run on Northern Rock in the United Kingdom in 2007. A liquidity shortfall at a single organization can have systemic repercussions, as the credit crunch of 2007–08 showed. That is why managing liquidity is one of the most important activities for banks to perform well.

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Advantages

Identifying weak points in your liquidity is important because:

  • it will enable you to manage your assets better during difficult financial periods as well as during good ones;

  • it will ensure that you (as an individual or an organization) have a diverse portfolio of assets and investments that will cover more risk scenarios.

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Disadvantages

  • The effort involved in identifying weak points in your liquidity may seem superfluous in good times.

  • It requires expenditure to create and set up the necessary processes for liquidity management.

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Action Checklist

  • Analyze your cash flow-based liquidity gap.

  • Carry out scenario-based analyses.

  • Perform liability modeling and stress-testing.

  • Implement a liquidity policy that will identify methods, processes, and responsibilities.

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Dos and Don’ts

Do

  • Analyze your liquidity provision.

  • Diversify your funds.

  • Implement regular liquidity status reporting.

  • Consider planning for a contingency fund.

  • Make sure your reporting system is accurate, informative, regular, comprehensive, and realistic.

Don’t

  • Don’t maintain a large number of illiquid assets.

  • Don’t go too far the other way and turn all your prime assets into cash.

  • Don’t ignore liquidity when times are good.

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Further reading

Books:

  • Fiedler, Robert. Liquidity Modelling. London: Risk Books, 2011.
  • Matz, Leonard, and Peter Neu (eds). Liquidity Risk Management. Singapore: Wiley, 2006.

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