What is Liquidity ?

Liquidity refers to the ability to convert an asset into another type of asset without any hindrance or loss. Assets that can be easily bought or sold are known as liquid assets, and this capability is termed liquidity. Cash, marketable securities, demand and savings deposits in banks, and other current assets are considered liquid assets.

Identification of Liquid Assets

The identification of liquid assets depends on the business's purpose, nature, and transactions. Liquid assets are essential for business operations, addressing short-term liabilities, avoiding future crises, and taking advantage of market opportunities. There is an inverse relationship between liquidity and profitability, so excessive hoarding of liquid assets is not wise.

Relationship Between Liquidity and Interest Rates

There is a close but inverse relationship between liquidity and interest rates. Higher liquidity lowers interest rates, which discourages savings and increases consumption. Conversely, lower liquidity raises interest rates, encouraging savings and helping in capital formation. Extreme fluctuations in interest rates are unfavorable for investment and economic activities.

Liquidity Management

Sources of liquidity management include increases in deposits, loan recovery, sale of banking assets, and borrowing from the money market. Its utilization includes loan disbursement, operational expenses, tax payments, and dividend payments. Banks often face challenges of either liquidity shortage or excess liquidity.

Liquidity Management in Nepal

The Nepal Rastra Bank manages liquidity using various tools through monetary policy. These include repo, reverse repo, outright sale, outright purchase, deposit collection, and issuance of Nepal Rastra Bank bonds to regulate the flow and absorption of liquidity in the market. Policy rates like the standing liquidity facility, required reserve ratio, statutory liquidity ratio, and bank rate are also used.

Three Dimensions of Liquidity Management

- Identification: Identifying various reserves affecting liquidity, determining positions, collecting, and processing data.

- Management: Integrating, grouping, and utilizing liquid assets.

- Utilization: Using liquid assets to maximize income.

Tools

- Repo: Tool for short-term liquidity provision.

- Reverse Repo: Tool for short-term liquidity absorption.

- Outright Sale: Tool for long-term liquidity absorption.

- Outright Purchase: Tool for long-term liquidity provision.

- Deposit Collection: Tool for exceptional liquidity absorption.

- Nepal Rastra Bank Bonds: Tool for structural liquidity absorption.

Conclusion

Liquidity management is essential for maintaining financial sector stability and price stability. The Nepal Rastra Bank aids liquidity management using various tools.