Banks or other lending institutions use liquidity gaps to assign interest rates to loans made to individuals and organizations.
A liquidity gap is a measure of the difference between the total net assets of a person or organization in relation to 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 a person’s or organization’s liquidity gap at a single point in time or at two or more times and compare the change in the liquidity gap. An organization may 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 value of the person’s or organization’s net assets, such as bank accounts or investment portfolios, minus any liabilities incurred by the person or organization. A negative gap means that the person or organization is earning less income than the amount of liabilities assumed. When the gap is positive, the person or organization has net assets remaining after all responsibilities have been fulfilled.
Banks or other lending institutions use liquidity gaps to assign interest rates to loans made 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 feels that the gap will not improve significantly in the near future, the lender may choose not to lend money or offer the loan at significantly higher interest rates.
A person’s or organization’s liquidity gap typically fluctuates over time at different rates because various factors can affect the amount of the gap. When the cost of living or conducting business increases and the income of the person or organization does not increase in the same proportion, the difference becomes more negative. When the organization or person takes on a new responsibility, 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 lender or potential investor make investment decisions. Based on the gap value information, the lender or potential investor can determine which direction the borrower’s finances are heading. The difference in gap values between two or more points in time is called the marginal gap.