What is liquidity risk?
Liquidity is the ability of a business, a business or even an individual to pay their debts without suffering catastrophic losses. Conversely, liquidity risk arises from the lack of negotiability of an investment which cannot be bought or sold quickly enough to avoid or minimize a loss. This usually results in unusually large bid-ask spreads or large price movements.
Key points to remember
- Liquidity is the ability of a business, a business or even an individual to pay their debts without suffering catastrophic losses.
- Investors, managers and creditors use liquidity measurement ratios when deciding the level of risk within an organization.
- If an investor, business or financial institution cannot meet its short-term obligations, it faces liquidity risk.
Explanation of liquidity risk
The rule of thumb is that the smaller the size of the security or its issuer, the higher the liquidity risk. The decline in the value of stocks and other securities prompted many investors to sell their holdings at all costs in the aftermath of the September 11 attacks, as well as during the global credit crisis from 2007 to 2008. This rush for exits caused a widening bid-ask spreads and a sharp drop in prices, which further contributed to the illiquidity of the market.
Liquidity risk arises when an investor, business or financial institution cannot meet its short-term obligations. The investor or entity may not be able to convert an asset to cash without giving up capital and income due to a lack of buyers or an inefficient market.
Liquidity risk in companies
Investors, managers and creditors use liquidity measurement ratios when deciding the level of risk within an organization. They often compare short-term liabilities and liquid assets listed in a company’s financial statements. If a business has too much liquidity risk, it must sell its assets, generate additional income, or find another way to reduce the gap between available cash and debt.
Liquidity risk in financial institutions
Financial institutions depend to a large extent on the money borrowed, so they are generally examined to determine whether they can honor their debts without making large losses, which could be catastrophic. Institutions are therefore faced with strict compliance requirements and stress tests to measure their financial stability.
The Federal Deposit Insurance Corporation (FDIC) released a proposal in April 2020 that created a stable net funding ratio. It was intended to help increase the liquidity of banks in times of financial stress. The ratio indicates whether banks have enough high-quality assets that can be easily converted to cash in one year rather than the current 30-day limit. Banks are less dependent on short-term funding, which tends to be more volatile.
During the 2008 financial crisis, many large banks failed or faced insolvency problems due to liquidity problems. The FDIC ratio complies with the international Basel standard, created in 2020, and it reduces the vulnerability of banks in the event of a new financial crisis.
A concrete example
A $ 500,000 house may have no buyers when the housing market is down, but the house may sell above its posted price when the market improves. The owner can sell the house cheaper and lose money in the transaction if he needs the money quickly, so he must sell while the market is down.
Investors should consider whether they can convert their short-term debt securities into cash before investing in long-term illiquid assets to hedge against liquidity risk.