What Is a Liquidity Cushion?
A liquidity cushion refers to the cash or extraordinarily liquid assets that an individual or company would possibly dangle to satisfy unexpected requires for cash throughout a liquidity crisis.
Key Takeaways
- Liquidity refers to the cash assets a company or specific particular person has to be had. Property that are not cash and hard to turn into cash in short are illiquid.
- Cash in reserve is a hedge against external shocks to an individual or company’s operating expenses.
- A company or specific particular person’s operating expenses, their tasks (like debt expenses) versus their income, will have a thin margin. When that’s the case, having a liquidity cushion method they would possibly not should advertise illiquid assets to cover expenses if there is a shortfall in income.
A liquidity cushion of cash reserves or money market gear can prevent a company from having to advertise additional illiquid securities or other investments – most likely at a loss – to boost cash to satisfy short-term tasks like repaying loans, bills or wages. A liquidity cushion is continuously known as a “rainy day fund.”
How a Liquidity Cushion Works
A liquidity cushion protects an individual or a business from having to advertise illiquid assets like precise belongings or equipment to pay off cash owed.
The equivalent concept applies to banks and other financial institutions that acquire and advertise assets by the use of borrowing money, often referred to as purchasing and promoting using leverage. If a company or broker is just too extraordinarily leveraged and they don’t have a liquidity cushion or cash reserve, they may be able to be pressured to advertise assets at a loss if they may be able to’t dip into cash reserves to provider debt tasks.
The opposite of a liquidity cushion is a liquidity crunch, where an individual or a company finds it does not have the cash to be had to pay their tasks by the use of the due date. In finance, when banks do not have the cash to cover depositors’ requires for money, it’s known as a liquidity crisis.
Examples of a Liquidity Cushion
Automotive corporations, for example, are good to stick a bit of of a cash buffer, given that their industry is so cyclical. The Ford Motor Company, for example, having long understood that financial smartly being is very important to its excellent fortune, mortgaged all of the company’s assets for $23.6 billion in loans in November 2006, to finance an overhaul and gives it a cushion to protect itself against a recession.
This shrewd switch was once to finally end up Ford’s salvation. By contrast to Customary Motors and Chrysler, it did not need to be bailed out by the use of the government throughout the global financial crisis. Nor did Ford have to offer any concessions to union body of workers as a scenario for Federal help. Moreover, its self-sufficiency moreover develop into a valuable promoting and advertising instrument.
Ford is slightly a really leveraged company, and while it could do additional to cushion itself against some other recession, it has $21 billion in cash set aside for a rainy day (provide as of Q1 2022).
In a similar fashion, The Dodd-Frank Wall Facet highway Reform and Client Protection Act of 2010 (Dodd-Frank Act) requires banks to have a liquidity cushion in case of some other financial crisis similar to the financial crisis of 2008. In step with the Federal Housing Finance Corporate, “The Dodd-Frank Act requires sure financial corporations with basic consolidated assets of more than $250 billion, and which may well be regulated by the use of a primary federal financial regulatory corporate, to behaviour annual stress tests to unravel whether or not or no longer the corporations have sufficient capital to soak up losses and make stronger operations throughout hostile monetary conditions.”
