What is liquidity risk?
Let us start by recalling what the term ‘liquidity’ stands for. Liquidity is the ability of a company or an individual to pay its debts by selling off its assets or securities without suffering tremendous losses. Basically, it describes how quickly something you own can be converted into cash.
The liquidity risk definition refers to the lack of marketability of a security or asset, which cannot be sold or bought quickly enough to prevent or minimise a loss. It is typically reflected in large price movements or uncommonly wide bid-ask spreads.
Simply put, liquidity risk, as an expression, describes the possibility that an individual trader or business may not be able to convert its assets into cash and meet its short-term financial obligations without giving up capital and income in the process.
Generally, liquidity risk arises when immediate cash needs cannot be satisfied due to the illiquidity of an asset, or due to market inefficiency.
Where have you heard about liquidity risk?
Prior to the global financial crisis, the majority of financial institutions took liquidity for granted, paying little to no attention to the availability of funds. Liquidity risk had not been on the radar until it hit all the news headlines during the crisis in 2007 - 2008.
During this time, many institutions struggled to maintain adequate liquidity. It resulted in both bank failures and the need for central banks to inject liquidity into national financial systems to keep the economy afloat. This extreme risk was a major factor in the weakness of financial institutions and ultimately led to the bankruptcy of Lehman Brothers.
The global crisis forced governments and major financial institutions to reassess the importance of liquidity. Today, they are aware of the risk that comes with insufficient liquidity and take necessary actions to prevent it from happening.
For example, in 2013, UK financial regulators agreed new rules on the minimum amount of liquid assets that all banks must hold to quickly convert these into money if needed.
What you need to know about liquidity risk.
All businesses seek access to capital to not only accomplish long-term strategic investments, but also to meet their short-term financial obligations. In turn, failure to acquire sufficient funding within a realistic timespan could expose a company to liquidity risk, resulting in negative consequences.
In regard to securities, liquidity risk occurs when the bid-ask spreads are widening out to levels where investors need to spend large amounts of money to deal with them.
There are two main types of liquidity risk: market and funding.
Market liquidity risk. It is the possibility that when you need to trade, the market liquidity is poor, making it difficult to buy or sell assets. For example, assume you own an expensive car. You need to sell it quickly. However, due to bad market conditions, it can only be sold at a low, discounted price. In this case, the asset does have a value, but owing to the temporary lack of buyers, this value cannot be realised.
Funding liquidity risk. It is the possibility that when a company needs to pay off its bills, it may fail to do so on time due to a lack of funding. For example, during the period of slowdown, the business may be exposed to funding liquidity risk if its obligations due at that time are greater than the operating cash flows generated.
Market liquidity risk can be measured by bid-ask spread, market depth, immediacy and resilience. Fund liquidity risk can be measured by the current ratio, which divides current assets by current liabilities, or by the quick ratio, which divides the total cash and equivalents plus marketable securities and accounts receivable by the total current liabilities.