Traditional ratios fail to accurately measure liquidity

Traditional liquidity metrics “leave much to be desired”, said Leonard Matz, managing director of Kamakura Corporation, at an address at the World Bank in Washington, DC. His talk was part of a workshop on assessing, managing and supervising financial risk, focusing on emerging markets.

Common liquidity measures do not accurately value liquidity risk, he said. Most metrics use historical data, making them useful as retrospective tools rather than future indicators of liquidity risk, said Matz. The increasing popularity of securitisation and other off-balance-sheet commitments are also not captured by traditional metrics that derive data from financial statements.

Loan-to-deposit ratios, which he referred to as “venerable, oft-quoted and almost meaningless,” bore the brunt of criticism. The ratio makes false assumptions, he said. The loan-to-deposit ratio assumes that all sources of funding other than deposits are stable, that all deposits are unstable, that all assets other than loans are completely liquid and that loans are completely illiquid. However, that is “not the case”, he said.

The solution is to measure the quantity of liquidity you have or can get relative to the quantity of liquidity that you think you may need. Practitioners should also sum current liabilities they may lose plus new assets they may have to fund, and also measure liquidity using scenario analysis.