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Liquidity Risk

Liquidity RiskTogether with the credit, market, operational, volatility risk, etc., liquidity risk is a form of financial risk.

What Is Liquidity Risk?

It is the impossibility of buying or selling a specific asset quickly enough to prevent a loss or make at the required profit. There are two types of liquidity risk: market (or asset) and funding. The market risk refers to an impossibility to sell an asset because the market is not liquid enough because of:

  • Widening of the bid/ask spread

  • Making explicit liquidity reserves

  • Prolonged holding periods for the value at risk calculations

  • Low immediacy, i.e. time required to successfully trade a specific amount of an asset at a certain cost

  • Low resilience, i.e. the ability of the price to quickly return to former levels after a large transaction

The funding risk is a risk that the liabilities cannot be met when they are due, can be name-specific or systemic, and can only be met at a non-profitable price.

The liquidity risk is caused by situations when someone who is interested in trading an asset cannot do it because nobody in the market wants to trade for that asset. This is why it is typically higher in emerging or low volume markets.

Financial institutions such as banks may lose liquidity because of falling credit ratings or unexpected cash outflows. As they depend on borrowed money, they face strict compliance requirements and stress tests to measure their financial stability. During the financial crisis in 2007-2008, many banks faced insolvency issues because of liquidity problems. Companies are also exposed to liquidity risk if the markets on which it depends are subject to liquidity risk, too.

How to Measure

It has to be managed together with the market, credit and other types of financial risks because these risks can depend on each other. Such dependability makes it difficult to identify and measure LR against other risks. A simple test is to look at future net cash flows on a daily basis. A significant negative net cash flow can indicate LR.

Such methods cannot consider conditional cash flows, such as those from derivatives or mortgage-backed securities. In such cases, it may be calculated with the help of scenario analysis, which may involve the following steps:

  1. Build several scenarios for market movements and defaults over a specific time period.

  2. Evaluate the daily cash flows under each scenario.

The LR can also be measured according to the following criteria:

  • Liquidity gap – the excess value of a company's liquid assets over its volatile liabilities. A firm with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values.

  • Elasticity - the change of net assets over funded liabilities that occurs when the liquidity premium on the bank's marginal funding cost rises by a small amount.

Investors, managers, and creditors use liquidity measurement ratios when evaluating the level of risk within a company. They often compare short term liabilities and liquid assets listed on an organization’s balance sheet. If a firm’s LR is too high, it must sell its assets, bring in extra revenue, or find another way to reduce the discrepancy between assets and liabilities.

Summary

Liquidity risk is a type of financial risk that is related to asset trading. LR occurs when it is impossible to buy or sell a certain asset quickly enough to prevent a loss or make the required profit. LR typically depends on two factors: funding and market. There are no 100% reliable LR measurement criteria because it is difficult to set it apart from other types of financial risk.