Why is liquidity a risk?
Liquidity is the risk to a bank's earnings and capital arising from its inability to timely meet obligations when they come due without incurring unacceptable losses.
Liquidity risk is the risk of loss resulting from the inability to meet payment obligations in full and on time when they become due. Liquidity risk is inherent to the Bank's business and results from the mismatch in maturities between assets and liabilities.
Key Takeaways
Liquidity risk arises when an entity, be it a bank, corporation, or individual, faces difficulty in meeting short-term financial obligations due to a lack of cash or the inability to convert assets into cash without substantial loss.
An example of liquidity risk would be when a company has assets in excess of its debts but cannot easily convert those assets to cash and cannot pay its debts because it does not have sufficient current assets. Another example would be when an asset is illiquid and must be sold at a price below the market price.
Lesson Summary. A liquidity risk is defined by an entity's lack of cash that hinders it from repaying short-term debt, resulting in excessive capital losses. Bank runs are often the result of banks running liquidity risks, where a lot of depositors simultaneously demand their money from a bank.
Liquidity risk is the risk of an institution's inability to meet its financial obligations as they fall due without incurring unacceptable cost or losses. These guidelines provide financial institutions with guidance on the key principles of, and sound practices for liquidity risk management.
Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.
FOR A BUSINESS, LIQUIDITY RISK DESCRIBES A POTENTIAL INABILITY TO ADDRESS SHORT-TERM CASH OUTFLOW. FOR INVESTORS, ON THE OTHER HAND, IT DESCRIBES THE RISK OF NOT FINDING COUNTERPARTIES WILLING TO PAY THE APPLICABLE MARKET PRICES FOR THEIR TRANSACTIONS.
It can also be a hurdle for business expansion. Excess liquidity suggests to investors, shareholders, and analysts that the firm is unable to effectively utilise the available cash resources or identify investment opportunities that can generate revenues.
Reasons that banks face liquidity problems include over-reliance on short-term sources of funds, having a balance sheet concentrated in illiquid assets, and loss of confidence in the bank on the part of customers. Mismanagement of asset-liability duration can also cause funding difficulties.
What does liquidity risk most affect?
To put it simply, liquidity risk is the risk that a business will not have sufficient cash to meet its financial commitments in a timely manner. Without proper cash flow management and sound liquidity risk management, a business will face a liquidity crisis and ultimately become insolvent.
It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.
- The current ratio or working capital. This compares current assets, including inventory, and liabilities.
- The acid test, or quick ratio. This measures only current assets, such as cash equivalents, against liabilities.
- The cash ratio or net working capital.
The three main types are central bank liquidity, market liquidity and funding liquidity.
Liquidity is a bank's ability to meet its cash and collateral obligations without sustaining unacceptable losses. Liquidity risk refers to how a bank's inability to meet its obligations (whether real or perceived) threatens its financial position or existence.
The bottom line on liquidity
Liquidity refers to the amount of money an individual or corporation has on hand and the ability to quickly convert assets into cash. The higher the liquidity, the easier it is to meet financial obligations, whether you're a business or a human being.
High-risk investments typically offer lower levels of liquidity than mainstream investments, so, particularly if something's gone wrong and performance hasn't met expectations, getting access to your money when you want may not be as easy.
Mitigation of liquidity risk can start with a complete understanding of the ratios you are monitoring, those you should be monitoring, an assessment of your financial planning and analysis efforts, and perhaps more frequent forecasting of cash flow.
As liquidity creation increases, banks are forced to dispose of their illiquid assets to meet depositor withdrawals, thereby raising the risk of failures when assets become insufficient to meet non-contingent commitments (Allen and Gale, 2004).
This is a “liquidity” problem. System wide illiquidity can make banks insolvent: With consumption goods in short supply, banks can be forced to harvest consumption goods from more valuable, but illiquid, assets to meet the non-negotiable demands of depositors.
What are the two reasons liquidity risk arises?
Liquidity risk occurs because of situations that develop from economic and financial transactions that are reflected on either the asset side of the balance sheet or the liability side of the balance sheet of an FI.
To remain viable and avoid insolvency, a bank needs to have enough liquid assets to meet withdrawals by depositors and other obligations that fall due in the near term.
- Central Bank Liquidity Risk. It is a common misconception that central banks cannot be illiquid due to the widespread belief that they will always provide cash when required. ...
- Funding Liquidity Risk. ...
- Market Liquidity Risk.
Other drivers that affect liquidity are securities that are held to maturity (HTM) by investors, the amounts outstanding of benchmark issues, taxes, arrangements for repurchase, clearing and settlement practices, as well as development of other allied segments of the market such as repo, when issued, short-sale, etc.
Liquidity Risk Indicators: Low levels of cash reserves, high dependency on short-term funding, or a high ratio of loans to deposits can hint at liquidity risk. Such indicators help banks ensure they can meet their financial obligations as they come due.
