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What Is a Liquidity Gap?

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  • Written By: Steven Symes
  • Edited By: A. Joseph
  • Last Modified Date: 04 September 2016
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A liquidity gap is a measure of the difference between a person or organization’s total liquid assets versus the total number of liabilities assumed by that person or organization. Also called liquidity mismatch risk or liquidity mismatch, it is one way of measuring a person's or organization’s level of financial risk. A bank or group of investors might measure a person's or organization’s liquidity gap either at a single point in time or at two or more times and compare the change in the liquidity gap. An organization might even choose to measure its own liquidity to assess its financial health.

Whether the gap being measured is for a person's or an organization’s finances, the basic method of calculating the gap is the same. The equation consists of the amount of the person's or organization’s liquid assets, such as bank accounts or an investment portfolio, minus any liabilities incurred by the person or organization. A negative gap means that the person or organization is netting less income than the amount of liabilities assumed. When the gap is positive, the person or organization has liquid assets left over after all of the liabilities have been fulfilled.

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Banks or other lending institutions use liquidity gaps to assign interest rates to loans made to both individuals and organizations. How high the interest rate for a loan is depends on how much risk the lender believes is involved in the loan transaction. If the person or organization applying for a loan has a negative gap, and the lender thinks that the gap will not improve significantly in the near future, the lender might choose either to not loan any money or to offer the loan at a significantly higher interest rate.

A person's or organization’s liquidity gap normally fluctuates over time at different rates because various factors might affect the amount of the gap. When the costs of living or conducting business increase, and the person's or organization’s income does not increase at the same rate, the gap becomes more negative. When the organization or person assumes a new liability, such as taking out a new loan, the gap becomes more negative.

Measuring a liquidity gap value at two or more points in time helps a potential lender or investor make investment decisions. Based on the information from the gap values, the potential lender or investor can determine which direction the borrower's finances are heading. The difference in the gap values between two or more points in time is called the marginal gap.

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Discuss this Article

fify
Post 3

I think that economics involves a lot of guess work. This also applies to liquidity gap. A firm has to constantly analyze interest rates and their future earnings to see if the liquidity gap will be positive or negative. Their prediction might be accurate or not.

ddljohn
Post 2

@SarahGen-- I'm not an economist but I think that financial risk is the risk that a company will not be able to cover its expenses. It's not even about profits, it's about staying afloat.

If a business' expenses increase so much that they cannot afford them, the business will be at risk of bankruptcy. It needs to be able to pay its expenses at all times. This means that it must have enough liquid assets. Liquid assets are basically assets that can be sold quickly and at high prices. It could be cash, gold or government bonds. If a business does not have enough liquid assets to cover potential future expenses, that business has a negative liquidity gap. So

there is a risk that this business will not make it if expenses were to increase.

They can take loans to manage this type of situation, but like the article said, banks are not too keen on lending to business with large liquidity gaps. Because the bank feels that they may never get their money back, which will be the case if the business files for bankruptcy.

SarahGen
Post 1

I'm not sure if I understand liquidity gap. What does financial risk mean? Is liquidity gap measuring profitability?

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