Definition: Liquidity risk is a firm’s possible inability to meet its short-term debt obligations, thereby incurring exceptionally large losses. This usually occurs as a result of a firm’s inability to convert its current assets into cash without incurring capital losses.
What Does Liquidity Risk Mean?
What is the definition of liquidity risk? All firms seek access to lending to meet their short-term financial obligations, but also to carry out long-term strategic investments. Failure to acquire appropriate funding within a realistic timeframe could expose a firm to liquidity risk, thereby causing undesirable consequences.
With respect to securities, this risk occurs when the ask-bid spreads are widening out to levels that investors need to spend large amounts of amount to deal with them. In general, this risk arises when a firm or an individual face immediate cash needs that cannot be met by selling an asset at its market value due to lack of buyers or due to an inefficient market that cannot match buyers with sellers.
Let’s look at an example.
Example
Emmanuel is an economist at Finanz Bank. Going over the Bank’s latest statistics, he notices that the percentage of portfolio transactions to the total assets has increased sharply, implying that the Bank is shifting towards a higher market risk.
Emmanuel wonders if this increase in the percentage of portfolio transactions is related to the Bank’s revenues. If it can be related, then the Bank has a satisfactory return with respect to the risk accepted.
Emmanuel goes over the Bank’s liquid assets. The sources of liquidity needed for responding to anticipated and unanticipated changes in the balance sheet are sufficient. 10% of the Bank’s assets can be immediately liquidated, which is generally a satisfactory percentage. However, Emmanuel wonders if 10% is a satisfactory liquidity percentage given the dynamics of the US market.
The answer is no. The main source of the Bank’s liquidity is the deposits. Financing sources like the interbank market and the term deposits add volatility to the level of commitment, thus increasing the Bank’s cost of money. If the Bank borrows in foreign currency, it introduces currency risk. Furthermore, the growing uncertainty following the regulatory liquidity requirements has forced banks to maintain a defensive attitude by putting a higher percentage of their balance sheets – more than 30% – in highly liquid assets.
Emmanuel writes a memo where he suggests the following liquidity improvement measures:
- Increasing the asset positions in readily marketable high-quality components
- Reducing the duration of assets
- Increasing the duration of liabilities
- Diversifying the money sources by duration, geographic area, and lender
- Studying the composition of deposits and extending the sources of fixed funding
- Increasing the loans that can easily be sold or securitized
With these liquidity risk management measures, the Bank is expected to increase its liquidity, thus avoiding exposure to liquidity risk in the short-term.
Summary Definition
Define Liquidity Risk: Liquidity risk is the chance that a company will not be able to service its short-term debt obligations and will have to pay additional fines and penalties or lose business.
