Liquidity risk is defined as the possibility of an asset failing to perform or difficulty in encashing an entity without a financial loss. It is an important financial risk that significantly impacts the operational functioning and financial stability of a business.
There are two main aspects associated with liquidity risk. These are market liquidity risk and funding liquidity risk. Market liquidity risk refers to a difficulty in executing transactions at the market prices that prevail. This can be due to market disruptions etc. On the other side, funding liquidity risk is the incapacity to receive enough financial funding to fulfill financial obligations.
In the rise of bank failures and great financial loss in businesses, a realization to better manage their liquidity, liquidity risk, and balance sheet was required! The consequences of poor liquidity management are not just limited to the business or bank itself. It can disrupt the entire financial ecosystem. Let us understand all these aspects better.
Liquidity Risk: Key Takeaways
- Liquidity risk arises when a bank or business fails to meet its financial obligations due to a lack of cash or the failure to encash its assets.
- Poor management of liquidity risk can lead to financial losses, operational failures, and reputational damage. In many cases, it can even lead to the bankruptcy or insolvency of the bank or business.
- Ways to successfully manage liquidity risk include maintenance of liquid assets portfolio, cash flow forecasting, and diversification of funding sources.
What is Liquidity Risk in Bank and Business?
Let us first understand what liquidity is. Liquidity is defined as the state of owning assets or entities that can be exchanged for cash. Thus, liquidity risk can be defined as the potential loss of cash which in turn affects the operations of a business or bank. In extreme cases, it may lead to the insolvency or bankruptcy of the financial institution.
Liquidity is the ability of a bank or business to fulfill its cash and financial obligations without incurring any losses. Conversely, liquidity risk is the inability of a bank or business to meet its cash and financial obligations without financial losses. It also threatens the financial position of a bank or business in the market.
It is a type of financial risk that showcases a failure to trade a financial asset, security, or entity for cash in the market without disrupting prices in the market. There are two main aspects of liquidity risk based on market fluctuations and funding issues. They are discussed below.
The Two Major Types of Liquidity Risk
There are two types of liquidity risk. These are Market Liquidity Risk and Funding Liquidity Risk. When an asset cannot be traded due to a lack of liquidity in the market, it is called market liquidity risk whereas funding liquidity risk arises due to a lack of funds.
Significant specifications associated with these risks are as follows:
| Market Liquidity Risk | Funding Liquidity Risk |
| It arises when there are fluctuations in the market such that conversions of assets into cash become difficult or lead to financial losses. | This risk arises when there is a need for more funding which disrupts the operational functioning of the business or bank. |
| Market liquidity risk is generally defined as a subset of market risk. | Funding liquidity risks can not be met when they have fallen due. |
| It can be accounted for by the widening-bid risk method. | They can only be fulfilled at an uneconomic price. |
| Making explicit reserves of liquidity and lengthening the period of VaR (Value at Risk) calculations are other ways to measure it. | Funding liquidity risk can be systematic or name-specific. |
How is liquidity risk related to market risk and credit risk?
Liquidity risk, credit risk, and market risk are all different types of financial risk that a corporation, business, or bank may face. However, they are all interrelated. A fluctuation in the prices of assets or other financial entities and the lack of liquidity in the market gives rise to market risk whereas credit risk arises from the failure of a borrower to meet its financial obligations.
In both these cases, a liquidity risk arises. When the assets are not able to be encashed because of market disruptions, it is called market liquidity risk. Thus, market liquidity risk is often studied as a subset of market risk. On the other hand, when funding can not reach businesses because of credit or debt default by borrowers then funding liquidity risk arises.
Similarly, an already existing liquidity risk poses market risk and credit risk. For instance, a business or bank facing liquidity problems can sell its assets in a market that is declining leading to financial losses and posing a market risk. On the other hand, this may cause the business to default on its credit creating a credit risk.
Strategic Ways for Sound Management of Liquidity Risk
In the absence of sound cash flow management and proper liquidity risk management, a bank or business faces a liquidity crisis and is threatened by the possibility of going bankrupt or insolvent.
This demands well-researched strategies to properly manage liquidity risk to protect against liquidity risk. However, without proper measurement of the liquidity risk at hand, it becomes highly difficult to manage liquidity risk.
Liquidity risk can be soundly managed by periodically forecasting cash flow, adequate financial planning, monitoring working capital, and optimizing credit facilities. These vital steps of liquidity risk mitigation are discussed below.
1. Liquidity Risk Measurement
Before a business or bank manages its liquidity risk, it is required to identify and measure the magnitude of the liquidity risk involved. There are varied ways to measure liquidity risk, given as follows:
A) Financial Ratio Analysis
Based on a business or bank’s past performance, financial ratios provide liquidity risk indicators. Quintessential financial ratios include quick ratio and current ratio.
Generally, businesses prefer the quick ratio over the current ratio. This is because most current assets are not liquid.
B) Cash Flow Forecasting
Forecasting cash flow in a realistic manner is an important step in the measurement and management of liquidity risk. This facilitates visibility in the management plan and accountability.
C) Capital Structure Management
A business or bank must look into its debt-to-equity ratio well. It shall see if it has required liquidity needed to pay its principal, debt and interest. It shall also make a comparison of its gearing ratios with its competitors.
Capital structure management can be done by using leverage ratios such as Debt-to-Equity ratio, Du-Pont analysis, and Interest Coverage ratio.
2. Regularly Forecast Cash Flow
All businesses regularly forecast their profit and loss but often do not forecast their cash flow as ill-liquidity never becomes a concern. However, it becomes important to forecast cash flow along with other financial aspects, especially to manage liquidity.
This will facilitate the reconciliation of the two important financial parameters of profit and cash flow. It is a significant step in liquidity risk management because profits are of no use to a business if they can not encash them for funding company operations.
3. Monitoring Net Working Capital
Optimization of net working capital is a vital way to manage liquidity risk so that a bank or business can fulfill its long-term financial obligations. Analysis of financial ratios such as current ratio and quick ratio with Cash Conversion Cycle (CCC) is a way to improve working capital.
Besides, three statement projections can be used to optimize net working capital. These incorporate Days Sales Outstanding (DSO), Days Payable Outstanding (DPO), and Days Inventory Outstanding (DIO) projections.
4. Optimizing Credit Facilities and Diversification
Banks and businesses use borrowed capital or lent money to adequately manage their short-term and long-term operational needs to grow financially and become profitable. These needs include bolstering cash reserves for net capital and capital expenditure requirements.
Thus, building a strong relationship with its lenders and monitoring its present credit facilities is required to manage debt maturities, ensure covenant compliance, and attain the most profitable financing rates.
Diversification of credit facilities is a major step in the management of liquidity risk. When a business is doing well financially, it shall develop good (durable and always available) credit liquidity lines.
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Liquidity Risk FAQs
Q1. What are the ways to measure liquidity risk?
Ans: Financial risk managers mainly use the quick ratio and common ratio methods to measure liquidity risk. The common ratio is pretty simple and represents a ratio between the current and the current liabilities of a corporation, business, bank or individual.
Q2. How is liquidity risk managed?
Ans: A simple way to manage liquidity risk is to diversify the sources of funding. This way, a constant flow of funds can be maintained throughout and protect against financial losses. Further, the maintenance of liquid assets portfolio and cash flow forecasting help in the mitigation of liquidity risk.
Q3. Does liquidity risk affect the economy?
Ans: Yes. Liquidity risk affects the broader economy in many ways. For instance, liquidity issues in big corporations pose problems of job losses and reduction in customer expenditure etc. Also, liquidity problems in large financial institutions may lead to a credit crunch during a financial crisis.
