Liquidity Cushion
What is a Liquidity Cushion
A liquidity cushion alludes to the cash or exceptionally liquid assets that an individual or company could hold to fulfill surprising needs for cash during a liquidity crisis.
A liquidity cushion of cash reserves or money market instruments can keep a company from being required to sell more illiquid securities or different investments - potentially at a loss - to raise cash to meet short-term obligations like repaying loans, bills or wages. A liquidity cushion is once in a while called a "stormy day fund."
How a Liquidity Cushion Works
A liquidity cushion safeguards an individual or a business from being required to sell illiquid assets like real estate or equipment to pay off debts.
A similar principle applies to banks and other financial institutions that buy and sell assets by borrowing money, otherwise called trading utilizing leverage. On the off chance that a company or trader is too exceptionally leveraged and they don't have a liquidity cushion or cash reserve, they can be forced to sell assets at a loss in the event that they can't dip into cash reserves to service debt obligations.
Something contrary to a liquidity cushion is a liquidity crunch, where an individual or a company finds it doesn't have the cash close by to pay their obligations by the due date. In finance, when banks don't have the cash to cover contributors' requests for money, it's called a liquidity crisis.
Real-Life Examples of a Liquidity Cushion
Vehicle companies, for instance, are insightful to keep a bit of a cash buffer, given that their industry is so cyclical. The Ford Motor Company, for instance, having long understood that financial wellbeing is key to its prosperity, sold every one of the company's assets for $23.6 billion in loans in November 2006, to finance an update and give it a cushion to safeguard itself against a recession.
This keen move was to demonstrate Ford's salvation. Dissimilar to General Motors and Chrysler, it didn't should be bailed out by the government during the global financial crisis. Nor forded need to give any concessions to union workers as a condition for Federal aid. Besides, its independence likewise transformed into a significant marketing tool.
Passage is all in all a profoundly leveraged company, and keeping in mind that it could accomplish other things to cushion itself against another recession, it has $31 billion in cash set to the side for a stormy day (current as of Q2 2020).
Essentially, The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) expects banks to have a liquidity cushion in case of another financial crisis like the financial crisis of 2008. As indicated by the Federal Housing Finance Agency, "The Dodd-Frank Act requires certain financial companies with total consolidated assets of more than $250 billion, and which are regulated by a primary federal financial regulatory agency, to conduct annual stress tests to determine whether the companies have adequate capital to ingest losses and support operations during adverse economic conditions."
Features
- Cash in reserve is a hedge against outside shocks to an individual or company's operating expenses.
- Liquidity alludes to the cash assets a company or individual has close by. Assets that are not cash and difficult to transform into cash rapidly are illiquid.
- A company or individual's operating expenses, their obligations (like debt payments) versus their income, may have a thin margin. At the point when this is the case, having a liquidity cushion means they will not need to sell illiquid assets to cover expenses on the off chance that there is a shortfall in income.
