Liquidity Gap

What Is a Liquidity Gap?

Liquidity gap is a term utilized in several types of financial situations to portray a disparity or mismatch in the supply or demand for a security or the maturity dates of securities. Banks deal with liquidity risks and potential liquidity gaps to the degree that they need to ensure they have sufficient cash available consistently to meet solicitations for funds.

At the point when the maturity of assets and liabilities vary, or there is surprisingly high demand for funds, the bank could experience a shortage of cash and, hence, a liquidity gap.

Understanding a Liquidity Gap

A firm could likewise experience a liquidity gap when they need more cash close by to meet operational needs and have assets and liabilities developing at various times. Liquidity gaps can likewise happen in the markets when there is a lacking number of investors to take the contrary side of a trade, and individuals who are hoping to sell their securities are unable to do as such.

For banks, the liquidity gap can change throughout a day as deposits and withdrawals are made. This means that the liquidity gap is even more a quick snapshot of a firm's risk, instead of a figure that can be turned out over for a long period of time. To compare periods of time, banks compute the marginal gap, which is the difference between gaps of various periods.

During the early months of the global financial crisis, a few bond and structured product investors found they couldn't sell their investments. There was a liquidity gap in that there weren't parties that were able to take the opposite side of the trade and purchase the securities at depressed prices. This lack of liquidity made markets in certain securities dry up for a considerable length of time.

Illustration of a Liquidity Gap

Hedge Fund ABC purchases $100 million worth of mortgage-backed securities (MBS) in February as the outlook of the housing market is strong and it accepts that the assets it purchased will give a constant flow of income for the foreseeable future. ABC likewise trusts that on the off chance that it at any point needs to sell its MBSs, it will have no problem doing so in light of the fact that liquidity in the market is high, with a lot of traded volume, with numerous buyers and sellers executing consistently.

As the year advances, the economy takes a downturn due to an extreme hurricane season obliterating crops and numerous important transportation ports. This thus causes huge job losses. Due to the job losses, numerous laid-off people are not able to pay their mortgages on time, causing defaults on their home loans.

Banks utilize an individual's liquidity gap to determine the interest rate they will charge on a loan. In the event that the liquidity gap is negative, a bank won't issue a loan or will charge a high interest rate.

Since no payments are being made on these home loans, which are the underlying assets of the MBSs, the MBSs begin defaulting, meaning no income stream is coming in. This makes the value of these MBSs fall. Hedge Fund ABC chooses to sell its portfolio of MBSs, which is presently valued at $70 million as opposed to $100 million, bringing about a loss of $30 million.

Notwithstanding, ABC is simply able to sell off $20 million of its portfolio and can't track down buyers until the end of its MBS portfolio. It attempts to sell the portfolio at a discount, in any case, buyers are not interested on the grounds that the housing market is in a free fall and nobody realizes how low it will go and assuming the value of the MBS portfolio will fall further. Hedge Fund ABC is encountering a liquidity gap where it has a portfolio of assets to sell however no buyers to sell it to.

Highlights

• To compare periods of time, banks compute the marginal gap, which is the difference between gaps of various periods.
• A liquidity gap can likewise happen when a company needs more cash close by to address operational issues.
• A liquidity gap in the financial world alludes to when there is a mismatch in the supply or demand for a security or the maturity dates of securities.
• Banks need to oversee conceivable liquidity gaps to guarantee that they are able to meet client deposit withdrawals consistently and not have too many deposits loaned out.
• During the financial crisis of 2008, numerous investors found themselves unable to sell securities as there were no investors able to buy securities at depressed prices, causing a lack of liquidity in numerous securities.

FAQ

What Kinds of Situations Might Arise in Which a Liquidity Gap Is Necessary?

There are no specific situations where a liquidity gap is important. Having a bigger number of assets than liabilities is generally a better situation as it allows for flexibility, growth, and an overall comfortable financial position. At times, in the event that a company is new and developing, and they are emptying all resources into growth, leaving minimal in liquid assets, consequently expecting them to borrow money to fund any liquidity gaps, it very well may be viewed however acceptable as the error may be being managed and utilized for growth.

Liquidity's meaning could be a little clearer.

Negative liquidity is when liabilities surpass assets, meaning that a company needs more assets to cover its obligations. The company has liquidity risk in this case.

How Is a Liquidity Gap Calculated?

A liquidity gap is calculated as assets minus liabilities. For a company, this would be all assets, like cash and marketable securities, and all liabilities, like short-term debt. Contingent upon the calculation, the numbers can either zero in on liquid assets and short-term liabilities or all assets and liabilities.