Liquidity Cushion

Liquidity Cushion

A liquidity cushion refers to the cash or highly liquid assets that an individual or company might hold to meet unexpected demands for cash during a liquidity crisis. A liquidity cushion refers to the cash or highly liquid assets that an individual or company might hold to meet unexpected demands for cash during a liquidity crisis. A liquidity cushion of cash reserves or money market instruments can prevent a company from having to sell more illiquid securities or other investments – possibly at a loss – to raise cash to meet short-term obligations like repaying loans, bills or wages. If a company or trader is too highly leveraged and they don't have a liquidity cushion or cash reserve, they can be forced to sell assets at a loss if they can't dip into cash reserves to service debt obligations. Similarly, The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) requires banks to have a liquidity cushion in case of another financial crisis similar to the financial crisis of 2008.

Liquidity refers to the cash assets a company or individual has on hand. Assets that are not cash and hard to turn into cash quickly are illiquid.

What is a Liquidity Cushion

A liquidity cushion refers to the cash or highly liquid assets that an individual or company might hold to meet unexpected demands for cash during a liquidity crisis.

A liquidity cushion of cash reserves or money market instruments can prevent a company from having to sell more illiquid securities or other investments – possibly at a loss – to raise cash to meet short-term obligations like repaying loans, bills or wages. A liquidity cushion is sometimes called a "rainy day fund."

Liquidity refers to the cash assets a company or individual has on hand. Assets that are not cash and hard to turn into cash quickly are illiquid.
Cash in reserve is a hedge against external shocks to an individual or company's operating expenses.
A company or individual's operating expenses, their obligations (like debt payments) versus their income, may have a thin margin. When this is the case, having a liquidity cushion means they won't have to sell illiquid assets to cover expenses if there is a shortfall in income.

How a Liquidity Cushion Works

A liquidity cushion protects an individual or a business from having to sell illiquid assets like real estate or equipment to pay off debts.

The same principle applies to banks and other financial institutions that buy and sell assets by borrowing money, also known as trading using leverage. If a company or trader is too highly leveraged and they don't have a liquidity cushion or cash reserve, they can be forced to sell assets at a loss if they can't dip into cash reserves to service debt obligations.

The opposite of a liquidity cushion is a liquidity crunch, where an individual or a company finds it does not have the cash on hand to pay their obligations by the due date. In finance, when banks do not have the cash to cover depositors' demands for money, it's called a liquidity crisis.

Real-Life Examples of a Liquidity Cushion

Automobile companies, for example, are wise to keep a bit of a cash buffer, given that their industry is so cyclical. The Ford Motor Company, for example, having long understood that financial health is key to its success, mortgaged all the company’s assets for $23.6 billion in loans in November 2006, to finance an overhaul and give it a cushion to protect itself against a recession.

This shrewd move was to prove Ford’s salvation. Unlike General Motors and Chrysler, it did not need to be bailed out by the government during the global financial crisis. Nor did Ford have to give any concessions to union workers as a condition for Federal aid. Moreover, its self-sufficiency also turned into a valuable marketing tool.

Ford is quite a highly leveraged company, and while it could do more to cushion itself against another recession, it has $31 billion in cash set aside for a rainy day (current as of Q2 2020).

Similarly, The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) requires banks to have a liquidity cushion in case of another financial crisis similar to the financial crisis of 2008. According to the Federal Housing Finance Agency, "The Dodd-Frank Act requires certain financial companies with total consolidated assets of more than $250 billion, and which are regulated by a primary federal financial regulatory agency, to conduct annual stress tests to determine whether the companies have sufficient capital to absorb losses and support operations during adverse economic conditions."

Related terms:

Bailout

A bailout is an injection of money from a business, individual, or government into a failing company to prevent its demise and the ensuing consequences. read more

Bank Panic of 1907

The Bank Panic of 1907 was a set of bank runs and bankruptcies that led industry leaders to draft the first version of the Federal Reserve System. read more

Cash Reserves

Cash reserves refer to the money a company or individual keeps on hand to meet short-term and emergency funding needs. read more

Cyclical Industry

A cyclical industry is sensitive to the business cycle, meaning revenues are higher in periods of economic prosperity, and lower in periods of downturn. read more

Dodd-Frank Wall Street Reform and Consumer Protection Act

Dodd-Frank Wall Street Reform and Consumer Protection Act is a series of federal regulations passed to prevent future financial crises. read more

Emergency Credit

Emergency credit is a government loan to a financial institution during a time of crisis. Such loans are often called bailout loans. read more

Emergency Fund

An emergency fund is a source of ready cash in case of an unplanned expense, an illness, or the loss of a job. Now there’s new help to build one. read more

Financial Crisis

A financial crisis is a situation where the value of assets drop rapidly and is often triggered by a panic or a run on banks. read more

Leverage : What Is Financial Leverage?

Leverage results from using borrowed capital as a source of funding when investing to expand a firm's asset base and generate returns on risk capital. read more

Liquid Asset

A liquid asset is an asset that can easily be converted into cash within a short amount of time. read more