If you have been following the financial sector in Ghana these past few months, you would have heard the word liquidity used a lot. But what exactly is it and why is everybody talking about it?

Liquidity refers to how quickly and easily a financial instrument or an asset can be converted into cash. An asset is liquid if it can be traded easily without the price of the asset being significantly changed. In accounting, a firm is liquid if it can meet its short-term obligations with its short-term assets. Liquidity is often said to be in conflict with profitability, since assets that are easily convertible to cash are those which offer the lowest returns.

This may not seem too significant a concept at first glance. After all, when we have bank balances or mobile money balances, they are as good as having cash. Our investments can always be redeemed for cash. And even assets like plots of land and vehicles can be sold for cash if we need it. But these are all assumptions.

For a monetary system to work well, the assumption of liquidity must not be threatened. People must have confidence that they can always sell their assets for cash. They must feel that their bank balances can always be withdrawn. A fall in this confidence such as happened in the USA during the Great Depression or the Great Financial Crisis can lead to bank runs in which banks collapse as customers rush to withdraw all of their deposits.

The recent closure of 7 banks in the country has brought the concept of liquidity to the mainstream in recent months. Liquidity is especially important for banks because they do not keep all the deposits in their vaults or with the central bank. Instead they keep the overwhelming majority of deposits in loans to clients and purchases of financial instruments. This is however not generally known to the public and many people believe that every digit in their bank account balance is physically backed by currency notes. This is why they think they should be able to withdraw whatever amount they want at anytime they want.

Banks meet these short-term demands for cash from their customers by borrowing from the central bank or other banks. In cases where the situation is daunting, banks take large facilities from the central bank (known as liquidity support) which attracts high interest rates as a way of punishing the bank for not managing its liquidity issues properly.

Financial firms can also face liquidity challenges. In the case where investors want to redeem their investments all at once, the finance firm may have challenges unwinding their long-term investments and settling their clients in cash. In the case where the whole industry is facing large withdrawals, firms are forced to sell their investments at what is known as fire sale prices i.e prices far below the listed value of the asset. This can have devastating effects on an economy.

For example, let’s assume you borrow money from a bank to buy a piece of land for GH¢10,000 hoping for a future rise in the market price of the land. Let’s assume that the interest rate of the loan is 10% annually. Theoretically speaking, as long as the price of the land rises by 10% annually, you are solvent i.e. the value of your assets (the land) is at least equal to the value of your liabilities (the bank loan). However, let’s say that a financial firm has bought lands in the same area as yours and then the customers of the financial firm wish to pull out their monies immediately. The firm will have no choice but to sell their land at whatever price the market will give them in order to meet their obligation. The value of land in the area will fall, and you may soon find yourself with a piece of land valued at GH¢5,000, although you owe the bank GH¢10,000, and you will be insolvent. This will mean you will be unable to repay the loan and the bank could collapse as a result of the bad loan.

The above scenario is similar to what happened in the financial crisis of 2007/8 in the USA when many households discovered that the amount they owed on their mortgages were higher than the value of their property. However, I will not go further on that as I plan to write another post on that topic.

In summary, customers of financial institutions assume that the assets of those institutions can always be converted to cash. However, that is not true and firms face liquidity challenges regularly. When these challenges are not well managed, whole financial systems can be at threat and economies can be severely harmed. It is important that stakeholders watch out for slacks in public confidence with respect to liquidity in the financial sector and ensure the stability of the sector.