Federal Reserve Bank of Cleveland
Press Release

For Release: December 23, 1997
Contact: John Martin, 216/579-2847 or June Gates, 216/579-2048

Firms Must Balance Liquid and Productive Assets to Make Profits and Attract Investors

Holding more cash-like, or liquid, assets than necessary can reduce a firm's ability to capitalize on profit-making opportunities, and make it less attractive to potential investors. A recent Economic Commentary published by the Federal Reserve Bank of Cleveland reviews the importance of liquidity to a firm, explores the downside of holding too much of it, and shows how changes in the liquidity of certain financial assets are affecting one industry, banking.

The Commentary's authors, economists Joseph Haubrich and Joćo Cabral dos Santos, say that the liquidity of an asset depends on the ease with which it can be traded or sold, with cash being the most liquid. Liquid assets enable a firm to pay its current liabilities. The tradability of liquid assets also allows managers to raise money under better conditions, since creditors can more easily evaluate the assets and sell them should seizure become necessary.

At the same time, liquid assets are generally less integral to a firm's unique production processes, and are hence less valuable to the business as a profit-making entity. And it is the profitability of a firm that ultimately provides value for investors. Productive assets, be they drill presses or mainframe computers, help a firm to make money, but are generally less easy to trade (or liquidate) if they are taken out of the firm's production environment and sold individually. In fact, say Haubrich and Santos, by gaining firm-specific value, an asset can become illiquid.

Therein lies the paradox of liqudity: investors can evaluate liquid assets more easily, but too much liquidity can make potential investors worry that a firm will not maximize its profit potential, or worse, that managers may divert these easily convertible assets to more self-serving purposes.

Haubrich and Santos say that understanding the liquidity trade-off provides a fresh perspective on some important economic issues, like the liquidity-driven changes in the functions and market positions of banks. Traditionally, by making long-term or illiquid loans, banks assured that they wouldn't expropriate their very liquid deposits. However, the ever-growing ability to transmit, store and collate information about mortgage, commercial and auto loans has allowed them to be more easily evaluated—making these formerly illiquid assets quite salable and increasing profit-making opportunities for banks and other financial intermediaries.

Ultimately, a firm's managers and its investors should have the same goal, to maximize the firm's profits. A firm's investment in productive assets is a sign of its commitment to this goal, but when liquid assets can also be used to maximize profits, investors should distinguish between potential expropriation and potential money-making opportunities.

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