A liquidity gap measures the difference between an individual’s or organization’s liquid assets and liabilities, indicating financial risk. Banks use it to assign interest rates to loans, and measuring it over time helps lenders make investment decisions.
A liquidity gap is a measure of the difference between a person’s 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 a way of measuring the level of financial risk of a person or organization. A bank or group of investors can measure the liquidity gap of a person or organization at a single point in time or 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 the finances of an individual or an organization, the basic method for 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 the liabilities incurred by the person or organization. A negative gap means that the person or organization is generating less revenue than the amount of liabilities assumed. When the gap is positive, the person or organization is left with liquid assets after all liabilities have been met.
Banks or other credit institutions use liquidity gaps to assign interest rates to loans granted to individuals and organizations. How high the interest rate on 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 the gap will not improve significantly in the near future, the lender might choose not to lend money or offer the loan at a significantly higher interest rate.
The liquidity gap of an individual or organization typically fluctuates over time at different rates because various factors can affect the amount of the gap. When the costs of living or doing business increase, and the income of the person or organization does not increase at the same rate, the gap becomes more negative. When the organization or individual takes on a new responsibility, such as applying for 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 in which direction the borrower’s finances are headed. The difference in gap values between two or more points in time is called the marginal gap.
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