Liquidity Function Essay Example | Topics and Well Written Essays - 1500 words

Liquidity Function - Essay Example Liquidity preference is the desire to hold cash. The money in cash and the rate of interest which is demanded in exchange for it is a "measure of the degree of our disquietude (ICFAI Center for Management Research (ICMR), 2005)." The rate of interest, in Keynes' words, is the "premium which has to be offered to induce people to hold the wealth in some form other than hoarded money." The higher the liquidity preference, the higher will be the rate of interest that will have to be paid to the holders of cash to induce them to part with their liquid assets. The lower the liquidity preference the lower will be the rate of interest that will be paid to the cash-holders. Transaction Motive: This motive is related to the "need of cash for the current transactions of personal and business exchanges." It is further divided into the income and business motives. The income motive is meant "to bridge the interval between the receipt of income and its disbursement", and similarly, the business motive is "the interval between the time of incurring business costs and that of the receipt of the sale proceeds." Precautionary Motive: The precautionary motive relates to the "the desire to provide for contingencies regarding sudden expenditures and for unforeseen opportunities of advantageous purchases." Banks keep cash in reserve to meet unexpected needs. Individuals hold some cash to provide for illness, accident, unemployment and other unforeseen contingencies. Money under the speculative motive is for "securing profit from knowing better than the market what the future will bring forth." Liquidity Vs Profitability Short run trade-off exists between liquidity and profitability. Other things remaining constant, the more liquid a bank the lower its return on equity and return on assets (The Banker, 2004). Both asset and liability liquidity contribute to this relationship. Facts about liquidity of a bank: The more liquid a bank, the less profitable the bank Liquid assets earn less than illiquid assets. The shorter the maturity, the lower the yield. The highest yielding loans are loans with the highest default or interest rate risk and are therefore the least liquid. Asset liquidity is influenced by the composition and maturity of funds i.e. the ease with which a bank can convert assets to cash with a minimum loss (Comptroller of the Currency Administrator of National Banks, 2001). Large holdings of cash assets evidently decrease profits because of the opportunity loss of interest income. In terms of investment portfolio, short-term securities yield lower returns compared to long-term securities. As investors value price stability and therefore long-term securities pay a yield premium over short term securities, to induce the investors to extend their holding period. For banks that purchase short-term securities, this increases the liquidity but at higher potential returns. For example, in an environment where market expectations are constant for short-term treasury yields, the treasury yield curve will slope upwards, reflecting liquidity premiums that increase with maturity. A bank's loan portfolio displays the same trade-off where the loans carrying the higher yields are the least