Liquidity risk is the inability to meet short-term financial obligations.
Liquidity risk is the possibility that an entity (whether a company, financial institution or individual) will be unable to meet its short-term financial obligations due to a lack of liquid assets or because it cannot convert its assets into cash quickly without suffer significant losses. It is a common risk in banks and financial institutions that depend on the immediate availability of funds to operate.
Examples of liquidity risk
Bank deposit withdrawal risk
A bank may face a liquidity risk if a large number of its customers decide to withdraw their deposits at the same time, as occurs in a bank run . If the bank does not have sufficient cash reserves or liquid assets to meet these demands, it may be forced to sell less liquid assets, which could lead to losses or even a solvency crisis.
Difficulties in selling financial assets
An institutional investor who owns large amounts of stocks or bonds could face liquidity risk if they need to sell those assets quickly due to a lack of buyers in the market. In illiquid markets, asset prices can drop sharply when trying to liquidate large volumes in a short time.
Company with illiquid assets
A company that has most of its capital in illiquid assets, such as property or machinery, may face problems if it urgently needs cash to cover its operating expenses. If you are unable to quickly sell these assets or access financing, you could default on payments.
Debt risk
A country may experience a liquidity risk if it does not have enough money for short-term debt repayment . This can happen if you are unable to issue new debt or if investors demand higher returns, making access to financing more expensive and leading to the risk of debt distress .
If many clients of a bank decide to withdraw their money at the same time, a liquidity risk arises.
Types of liquidity risk
Liquidity risk can manifest itself in various ways depending on the financial context and the instruments involved. Some notable types are described below.
Bank liquidity risk
The ability of banks to meet deposit withdrawal demands and other obligations. A bank may face liquidity problems if it cannot access sufficient funds in the short term.
Liquidity risk in stocks
The difficulty of selling shares quickly without significantly affecting their price, especially in less liquid markets.
Liquidity risk in bonds
Similar to equity risk, it refers to the ability to sell bonds without significant losses in value, which can be problematic in less active debt markets.
Liquidity risk in investment portfolios
Investors may face difficulties liquidating their positions in investment portfolios, especially if they include less liquid assets. This framework includes liquidity risk in mutual funds , where there may be restrictions on the redemption of units in periods of high demand.
Liquidity risk in derivatives
Derivative instruments may have significant liquidity risk, especially if traded in over-the-counter markets where depth and volume may be limited. It goes hand in hand with liquidity risk in swaps , since swaps are financial contracts in which two parties agree to exchange future cash flows or payments according to predefined terms.
Foreign currency liquidity risk
It occurs when an investor has difficulty converting currencies or assets and occurs along with liquidity risk in emerging markets , where liquidity may be limited and prices may fluctuate wildly.
Intraday liquidity risk
It refers to the ability of financial institutions to manage their cash positions throughout the day and the availability of funds between banks ( liquidity risk in the interbank market ), which is crucial to maintaining financial stability .
Liquidity risk in pension funds
These investment vehicles may have restrictions on access to capital , which may make it difficult to liquidate assets when necessary. It is closely related to liquidity risk in structured products : that an investor may not be able to sell or liquidate a structured product quickly without incurring significant losses, given the complexity and customization of these products, which may not have an active market, making it difficult its negotiation and valuation at any time desired.
Liquidity risk in the primary market
It relates to the issuance of new securities, while liquidity risk in the secondary market refers to the ability to buy and sell existing assets without affecting their market price.
Liquidity is the ease of converting assets into cash without their value being significantly affected.
Liquidity
Portfolio liquidity
The ease with which an investor can convert portfolio assets into cash without significantly affecting their value. A portfolio with high liquidity is made up of assets that can be sold quickly, while one with less liquid assets may face challenges in converting to cash.
Market Liquidity
It describes the overall ability of a market to facilitate the buying and selling of assets without causing large changes in their prices. A liquid market has a high transaction volume, allowing assets to be traded at stable prices.
Calculation of liquidity ratio
This calculation is used to evaluate an entity's ability to meet its short-term obligations. There are different ratios, such as the current ratio (current assets/current liabilities) and the quick ratio (liquid assets/current liabilities), which provide a measure of overall liquidity.
Liquidity indicators
Metrics that help evaluate the financial health of an entity in terms of liquidity. In addition to the mentioned ratios, other indicators include cash conversion cycle and operating cash flow .
Liquidity risk models
They allow financial institutions to evaluate and manage liquidity risk through simulations and statistical analysis. They help to anticipate stressful situations and make informed decisions about the management of assets and liabilities.
Liquidity gap analysis
Examines the difference between the expected cash flows of assets and liabilities in different periods. Identifying liquidity gaps allows organizations to anticipate potential cash shortfalls and plan accordingly.
Sensitivity analysis
Although not directly related to liquidity, this analysis evaluates how changes in certain variables (such as interest rates or asset prices) can affect the liquidity and performance of a portfolio.
stress tests
Simulations that evaluate how an entity could react to adverse situations, such as a drop in asset value or a massive flight of deposits. These tests help identify vulnerabilities in liquidity management.
financial stress
Situations in which entities face difficulties in accessing financing or meeting their financial obligations, often as a result of unfavorable market conditions.
Liquidity crisis
It occurs when an entity cannot obtain enough cash to meet its short-term obligations, which may lead to default. Liquidity crises can be caused by internal factors (such as poor treasury management) or external factors (such as a loss of market confidence).