Understanding Liquidity Gap Ratio and Related Liquidity Risk Metrics

Explore the liquidity gap ratio and how it measures a bank’s ability to meet short-term funding needs.

The Liquidity Gap Ratio is an essential financial metric used to assess an organisation’s ability to meet its short-term obligations using its liquid assets. It highlights potential mismatches between cash inflows and outflows across different time buckets, helping analysts evaluate liquidity risk and funding stability.

This ratio is an important part of liquidity risk management in banks, financial institutions, and corporates, as it signals whether an entity can handle unexpected cash demands without resorting to emergency borrowing or asset sales.

The Liquidity Gap Ratio (LGR) measures the difference between liquid assets (like cash, receivables, and short-term investments) and liquid liabilities (such as deposits and short-term debts) within specific maturity periods.

It helps determine whether the firm has adequate liquidity buffers to withstand short-term cash flow pressures.

Formula:

Liquidity Gap Ratio = (Liquid Assets ÷ Liquid Liabilities) × 100

• Liquid Assets include cash, government securities, and other marketable instruments easily convertible into cash.
  

• Liquid Liabilities refer to short-term obligations due within the same period.
  

Interpretation:

• LGR > 100% it means surplus liquidity; strong liquidity position.
  

• LGR = 100% it means balanced liquidity; cash inflows match obligations.
  

• LGR < 100% it means liquidity gap; potential shortfall risk.

The Liquidity Coverage Gap Ratio (LCGR) extends the basic liquidity gap concept and aligns it with Basel III Liquidity Coverage Ratio (LCR) norms.

It ensures that financial institutions hold sufficient High-Quality Liquid Assets (HQLA) to cover total net cash outflows over a 30-day stress period.

Formula:
Liquidity Coverage Ratio (LCR) = (High-Quality Liquid Assets ÷ Total Net Cash Outflows) × 100

Under Basel III, the minimum LCR requirement is 100%, meaning a bank must have enough liquid assets to survive a 30-day liquidity stress scenario.

The Funding Gap Ratio measures the structural mismatch between long-term assets and stable funding sources.

It’s a key indicator of balance sheet strength and funding sustainability.

Formula:

• Funding Gap Ratio = (Stable Funding Sources ÷ Long-Term Assets) × 100

A ratio below 100% signals reliance on short-term funding to finance long-term assets — an indicator of structural weakness.

A higher ratio indicates stable, well-matched funding.

The Liquidity Mismatch Ratio quantifies the imbalance between liquid assets and short-term liabilities in specific time frames.

It shows how quickly an organisation can generate cash to meet maturing obligations.

High Mismatch Ratio: Indicates insufficient liquid assets, posing solvency risks.

Low Mismatch Ratio: Suggests healthy liquidity management with minimal funding pressure.

The Liquidity Position Ratio evaluates the overall strength of a company’s liquidity reserves relative to its obligations.

Formula:

• Liquidity Position Ratio = (Total Liquid Assets ÷ Total Current Liabilities) × 100

A higher ratio demonstrates a strong liquidity cushion, while a low ratio signals vulnerability under stress conditions.

The Liquidity Deficit Ratio (LDR) measures the extent of shortfall between expected cash inflows and required outflows over a given time period.

Formula:

• Liquidity Deficit Ratio = (Total Outflows – Total Inflows) ÷ Total Assets × 100

A positive ratio reflects a deficit (riskier), whereas a negative ratio indicates a surplus liquidity position.

Here is a step-by-step method:

Step 1: Identify all time-bucketed cash inflows and outflows.

Step 2: Calculate the net liquidity gap = Total Inflows – Total Outflows.

Step 3: Compute each ratio (LGR, LCR, LDR) to analyse liquidity stability.

Example:

If a company has ₹12 crore of liquid assets and ₹15 crore of short-term liabilities:

Liquidity Gap Ratio = (12 ÷ 15) × 100 = 80%

This indicates a liquidity shortfall, meaning additional cash or funding sources are required.

A significant liquidity gap can:

• Trigger short-term funding pressure and reduce investor confidence.
  

• Force asset sales, leading to realised losses.
  

• Affect solvency, especially in banks during market stress.
  

• Create contagion risk — where liquidity stress spreads across markets.

A positive liquidity gap (surplus) enhances resilience, while a negative gap (deficit) signals funding or liquidity risk.

Liquidity ratios are useful but can mislead if applied mechanically without considering timing, context, and the quality of underlying assets. Here are a few common mistakes:

1. Ignoring time-bucket mismatches when computing gaps.
   

2. Overlooking off-balance sheet items like guarantees or contingent liabilities.
   

3. Using accounting liquidity instead of cash-based liquidity.
   

4. Failing to adjust ratios for market or seasonal variations.
   

5. Treating high liquidity as always positive — excessive liquidity can reduce profitability.

Liquidity management is central to an organisation’s financial stability. The Liquidity Gap Ratio helps assess whether short-term assets can meet short-term liabilities, revealing funding mismatches early.

Points to keep in mind:

• The Liquidity Gap Ratio is an important measure of liquidity health and short-term financial flexibility.
  

• It identifies potential shortfalls and supports timely funding or investment decisions.
  

• Related ratios like LCR, Funding Gap Ratio, and Liquidity Deficit Ratio offer complementary insights.
  

• Regular monitoring ensures compliance with Basel III norms and helps maintain financial stability.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.