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The Significance of Liquidity

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The Significance of Liquidity

The significance of liquidity is the ability to immediately cover debt obligations with money or assets on hand in other words, your ability to pay your bills. Liquidity might be your emergency savings account or the money lying with you that you can access in case of any unforeseen happening or any financial setback. 

Within a company the significance of liquidity it’s the company’s ability to pay its short-term debts, such as its current liabilities from its current assets. This is often used to quickly measure the liquidity of a company.  

A bank’s liquidity is determined by its ability to meet all its anticipated expenses, such as funding loans or making payments on debt, using only liquid assets. The failure of a bank is generally considered to be of more importance than the failure of other types of business firms because of the interconnectedness and fragility of banking institutions.  

Research has shown that Liquidity problems experienced by a particular bank can quickly and easily spread throughout the economy to other banks. And cause systemic risk, thereby causing contagion effects across an entire banking system. The Reserve Bank provides liquidity to banks during periods of temporary shortages of cash. This function is referred to as the Bank’s “lender-of-last-resort lending activities”. 

This function implies giving assistance to a bank facing liquidity problems. Such assistance is only given after a full analysis of the problems afflicting such a bank and the reasons they arose. The assistance will only be given on specific conditions, and its purpose is to prevent the bankruptcy of the bank receiving assistance, and to avoid the danger of problems spreading to other banks through a “run on the bank”. 

A bankrupt bank will often not be able to repay its depositors, and the main purpose of special assistance is therefore to protect depositors. However, such assistance is never guaranteed or given automatically, and banks may accordingly go bankrupt. This can lead to severe hardships for depositors who lose their deposits at such a bank. The maintenance of stability in the banking system is, therefore, of the utmost importance to any country.

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