Liquidity risk 

Liquidity risk 

In the stock market, liquidity is the ease with which an asset, such as equity shares, debentures, etc, can be exchanged for money. Since the successful conversion of stock into cash depends on several factors, including a company’s book value, the bid-ask spreads for its shares on the market, etc., liquidity risk represents the risks involved with such deals. When a financial asset or instrument cannot be traded within a specific timeframe, liquidity risk exists, which could result in an investment loss. 

What is liquidity risk? 

Liquidity risk is a monetary risk that occurs when a particular financial asset, security, or commodity cannot be traded rapidly enough without affecting the market price. Liquidity risk occurs when a party wanting to sell an investment cannot do so because no one else wants to deal with that asset.  

Since it affects their capacity to trade, liquidity risk becomes especially significant to parties planning to hold or already holding an investment. Creditors, managers, and investors use liquidity measurement ratios to assess an organisation’s risk. They commonly compare short-term commitments with the liquid assets listed in a company’s financial accounts. A corporation must sell off assets, increase income, or find other ways to make up the difference between its cash on hand and its debt obligations if its liquidity risk is too high. 

Understanding liquidity risk 

Banks are frequently linked to liquidity risk. Due to bad liquidity management, banks all around the world are experiencing problems as a result of the liquidity crisis. Since each transaction and commitment affect a bank’s liquidity, managing liquidity risks is essential.

Liquidity risk is one of the most critical elements of a company-wide risk management system. A bank’s liquidity system should maintain sufficient liquidity to survive any potential stress event. When a company, group, or financial institution cannot pay its short-term loan obligations, liquidity risk is more likely to arise. There are several possible causes for this.  

Due to their reliance on borrowed money, financial institutions are constantly scrutinised to determine whether they can make their debt payments without experiencing sizable losses that could be disastrous. As a result, institutions must follow strict compliance guidelines and submit to stress tests to determine their financial stability. 

 

Types of liquidity risk 

The following are the types of liquidity risk: 

  • Funding liquidity risk 

It is the risk that a business or investor cannot obtain the necessary funds to meet its financial obligations. This type of liquidity risk is most commonly associated with banks, as they rely on deposits to fund their operations. If the bank is unable to obtain the necessary funds, it may not be able to meet its financial obligations, leading to a run on the bank and eventual bankruptcy. 

  • Market liquidity  

It is the risk that an investor cannot sell an asset at its fair market value due to a lack of buyers. This type of liquidity risk is most commonly associated with stocks and bonds, as there is often a limited number of buyers for these assets. If the investor cannot sell the asset at a fair market value, they may be forced to sell at a loss, leading to significant financial losses. 

A lack of market liquidity prevents an asset from being sold, effectively a subset of market risk. Widening the bid-ask spread, creating explicit liquidity reserves, and lengthening the holding period for value-at-risk calculations can all be used to adjust for this.  

  • Asset liquidity risk 

Asset liquidity risk is when an investor can sell an asset quickly only after incurring significant losses. This liquidity risk is most commonly associated with illiquid assets like real estate and private equity. If the investor cannot sell the asset quickly, he may be forced to hold onto it for an extended period, leading to significant financial losses. 

Liquidity risk 

Why liquidity risk management is important 

The capacity to repay loans, firms, investors, financial institutions, and other entities are subject to liquidity risk. So, by creating appropriate strategies and taking proper measures to guarantee that the negative impacts of such risks are kept to a minimum, liquidity risk management assists organisations in reducing their risks. On the other side, liquidity risk measuring ratios are employed when investors, managers, or enterprises wish to determine the level of risk within their organisation.  

The development of risk management frameworks and methods has been motivated by numerous efforts made in recent years to understand risk and its nature. Since liquidity risk tends to compound other risks, addressing liquidity risk is crucial for managing market and operational risks.  

Consequently, organisations must specify their level of risk tolerance or risk appetite. Risk acceptance guarantees the company can control its risk liquidity in this way. To ensure that the company’s entire management fully understands the trade-off between risks and rewards, the organisation should explicitly state its risk tolerance.   

Example of liquidity risk 

The idea of liquid risk is shown in the example that follows. When the housing market is weak, a US$300,000 home might not sell because there is little demand, but when things turn around, the home might fetch more money than its asking price. If the owners need money right away and have to sell the house during a downturn in the market, they can get less for it and lose money on the deal.  

Before investing in long-term illiquid assets to protect themselves against liquidity risk, investors should assess if they can convert their short-term debt obligations into cash. 

 

Frequently Asked Questions

Liquidity risk arises from our future incapacity to make payments when they are due or from our potential ability to make payments but only at a high cost. 

 

Short-term liquidity risk is an issue. The persistent inability to fulfil long-term financial obligations is known as insolvency. Finding the ideal balance between investing and having enough cash on hand to cover expenses is key to reducing liquidity risk. 

 

Liquidity risk is computed by dividing current assets minus inventory by current liabilities. The ideal ratio is 1; anything over it indicates a solid ability to make payments, while anything below it indicates shortcomings. 

 

Improved risk reporting skills, better balance sheet management, improved risk metrics and monitoring procedures, and improved stress management are all ways to manage liquidity risk. 

Liquidity risk is the likelihood that a bank will require more cash on hand to fulfil its financial commitments in a timely manner.  

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