Liquidity risk is the risk that a financial institution or company will not be able to meet its financial obligations when they are due, either because it is unable to sell assets quickly enough to raise the necessary cash or because there are insufficient buyers for the assets. This can occur for a variety of reasons, including market volatility, changes in regulatory requirements, or a sudden decrease in the value of a company’s assets.
There are several types of liquidity risk, including funding liquidity risk, which is the risk that an institution will not be able to obtain the necessary funding to meet its financial obligations; market liquidity risk, which is the risk that an institution will not be able to sell its assets quickly enough to raise the necessary cash; and funding and market liquidity risk, which is the combination of the two.
To manage liquidity risk, financial institutions and companies can take a number of steps, including maintaining a sufficient level of liquid assets, such as cash and highly liquid securities, to meet short-term obligations; diversifying funding sources; and establishing lines of credit with banks or other financial institutions. They can also use financial instruments, such as repurchase agreements and securities lending, to help manage liquidity in times of stress.
It is important for financial institutions and companies to carefully manage their liquidity risk, as a failure to meet financial obligations can have serious consequences, including bankruptcy, loss of investor confidence, and damage to the company’s reputation. Regulators also pay close attention to liquidity risk, and may require financial institutions to hold certain levels of liquid assets or maintain minimum levels of funding.
In summary, liquidity risk is the risk that a financial institution or company will not be able to meet its financial obligations when they are due, either because it is unable to sell assets quickly enough to raise the necessary cash or because there are insufficient buyers for the assets. It is important to carefully manage liquidity risk to avoid serious consequences and to ensure compliance with regulatory requirements. The following are examples of liquidity risk.
An IT consulting firm relies on reasonably timely customer payments in order to meet quarterly cash needs. A dispute with a large customer results in a sudden decline in cash flows and the firm misses a payroll payment. This results in compliance issues, fines and a severe decline in reputation and employee satisfaction.
Generally speaking, banks don’t have the cash that would be required if all customers were to withdraw their deposits all at once. If economic conditions cause a large number of withdrawals, banks may require a large amount of cash in a short period of time.
Lines of Credit
In addition to deposits, unused space in lines of credit can quickly drain the liquidity of banks.
A manufacturing company has a small reserve of cash and a large unused line of credit. The firm experiences a period of rapidly declining prices due to industry oversupply. They quickly run out of cash as their operating margins turn negative. The line of credit becomes unavailable due to their poor financial metrics. The firm starts to miss payments and suppliers stop supplying them with essential inputs. The business goes into a downward spiral and is quickly bankrupt.
An investor purchases a low volume small cap stock. The investor suddenly requires cash due to a personal emergency but has trouble selling the stock due to the low volume. The investor must set the price surprisingly low before their order finally fills. This results in a loss. If the investor had owned a high volume stock it could have been sold instantly at a market price with a low bid-ask spread.
An investor who has all of their net worth in real estate generates cash by selling properties on a regular basis at a profit and purchasing new ones. This works for the investor while the market is hot. When market conditions change, houses are difficult to sell and it takes over a year to complete a single sale. The investor is short on cash and must sell a few properties at exceptionally low prices to attract buyers in a down market.