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How Do Finance Companies Manage Their Liquidity Risk ?
Financial institutions, especially the banks, manage liquidity risks by cautiously examining the relationship that exists between their current assets against their current liabilities. To be more precise, liquidity risk in a finance company can be managed by regulating its working capital requirements. |
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Liquidity risk management is accomplished by using stress tests on all the components of liquidity. These tests help to evaluate the possible effects on liquidity in case a change occurs in the prevailing conditions.
Following are certain steps taken by finance companies to keep a check on liquidity risks:
- Current liabilities: The debt instruments and deposits, which are to be paid within thirty days, constitute its current liabilities of a company. Deposits may include both time deposits and checking accounts. Debts payable, on other hand, include bonds payable, notes payable, etc.
- Notational liabilities: Standby I/Cs and other similar off-balance sheet liabilities are usually offered by finance companies to third-party beneficiaries as a guarantee that their money shall be paid even in case of a default. Real short-term debts are created from the Standby-I/Cs if loans are not paid within time. Thus, notational liabilities paid by banks are a good way to manage liquidity risk during economic slump.
- Current Assets: The short-term or current assets of a company constitute cash or equivalent instruments like securities, bonds, cash flows, and cash deposits. At any point of time, if the banks face a financial crunch, these assets are adjusted according to the prevailing market conditions.
To ensure that liquidity risk management policy is in place, regulators often require the finance companies to carry out shock tests or analysis to assess the current needs. Similarly, each finance company maintains its own liquidity risk management plan, elucidating the various actions that it would take in case of liquidity crisis.
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Liquidity Importance
 Till date, majority of investors go after stocks of technology companies ranging from Infosys Technologies to Mascon Global. Nonetheless, financial analysts have always discouraged the retail investors from purchasing certain stocks. Most of these stocks have a great growth potential, but are still not the recommended ones. Have you ever thought of the reason behind it? Well, the simple reason for this is that they are not at all liquid. More..
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