Liquidity, in the financial world, is the amount of money and credit that an entity can readily take in and out of the marketplace. To explain it with the simplest of examples, a characteristic mass flocking of players to the newest online casinos is an indication of a very liquid market around that specific industry, so too all the markets surrounding it.
The current credit crisis is not a liquidity crisis. Not yet, anyway.
Right now, there’s plenty of liquidity available for credit risk denials, settlement failures, insolvencies, margin calls, fines, sanctions, and regulatory measures.
That’s the good news.
As confidence is gained, liquidity can be used to finance deals and insulate institutions from potential margin swings or market disruptions.
I am a big believer in liquidity as an integral part of investing. The ability to pay back loans is the most critical factor in determining a financial institution’s future success.
No financial institution can prosper forever on cash and cash equivalents. It will eventually be forced to finance transactions with loans and other forms of liquidity.
Credit risk is an important part of banking and investing. But no matter what credit risk scenario arises, no bank can guarantee repayment of debts. Credit risk, liquidity risk, or credit risk, the financial structure must be flexible enough to change and reduce risk whenever necessary.
Liquidity is important. But it’s not the key to successful investing or banking.
No matter what kind of risk you’re faced with, the key to maximizing your potential for investment success lies in diversification.
A Contrarian View
Recent financial news is making it very clear that the markets are favoring liquidity as a means of furthering investment success.
Don’t get me wrong. Credit risk is a vital factor in creating a highly successful investment strategy. The ability to fund operations and projects will always be a critical part of our financial strategy.
But there’s also another category of financial risk — liquidity risk.
Contrarian investors can control their exposure to liquidity risk. This category includes risk of defaults by borrowers, market risk, bank risk, and market risk.
All banks are able to fund loans, lend out funds, and make settlements through liquid markets. There are some exceptions, such as bankruptcy and insolvencies, but for the most part, banks are liquid.
But why should an investor want to own banks with an abundance of liquidity when they can purchase investments with lower financial risk? It’s not just that financial institutions have lower liquidity risk. It’s also about managing liquidity risk.
Fraud, accounting, market risk, and fraud can, and will, become increasingly common within institutions. It’s impossible to quantify or measure all fraud risk, but it’s fair to say that fraud is a significant risk within institutions.
It’s important to have sufficient capital for financial losses incurred as fraud occurs. But it’s even more important to maintain sufficient capital to cover the losses when fraud has been exposed.
Corporate fraud can erode an institution’s reputation, customer base, funding, earnings, and future prospects.