Meaning of liquidity risk?
Liquidity risk refers to how a bank's inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM).
An example of liquidity risk would be when a company has assets in excess of its debts but cannot easily convert those assets to cash and cannot pay its debts because it does not have sufficient current assets. Another example would be when an asset is illiquid and must be sold at a price below the market price.
Liquidity risk is defined as the risk that the Group has insufficient financial resources to meet its commitments as they fall due, or can only secure them at excessive cost. Liquidity risk is managed through a series of measures, tests and reports that are primarily based on contractual maturity.
Liquidation risk is the possibility of losing your entire trading position if the market moves against you and your margin level falls below a certain threshold.
Liquidity risk often can arise from perceived or actual weaknesses, failures or problems in the management of other risk types. A bank should identify events that could have an impact on market and public perceptions about its soundness, particularly in wholesale markets.
It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.
The three main types are central bank liquidity, market liquidity and funding liquidity.
Management of liquidity risk is critical to ensure that cash needs are continuously met. For instance, maintaining a portfolio of high-quality liquid assets, employing rigorous cash flow forecasting, and ensuring diversified funding sources are common tactics employed to mitigate liquidity risk.
Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. Cash is the most liquid of assets, while tangible items are less liquid.
Liquidity Risk Indicators: Low levels of cash reserves, high dependency on short-term funding, or a high ratio of loans to deposits can hint at liquidity risk. Such indicators help banks ensure they can meet their financial obligations as they come due.
Is liquidation good or bad?
If a business has no viable future, a creditors' voluntary liquidation is a good way to close down the company. That's because: It encourages a constructive discussion between creditors, directors and shareholders on how to pay off as much of the company's debt as possible.
Liquidation involves the sale of all of a fund's assets and the distribution of the proceeds to the fund shareholders. At best, it means shareholders are forced to sell at a time, not of their choosing. At worst, it means shareholders suffer a loss and pay capital gains taxes too.
As a result, we argue that market liquidity risk is an integral part of market risk. Accordingly, market risk measurement should take account of liquidity risk.
For a business, liquidity risk typically comes from a lack of sufficient liquidity to cover lesser anticipated expenses. Two main causes for corporate liquidity risk may be identified: The absence of a sufficient “safety buffer” to cover overall expenses (the most unexpected ones in particular);
BANKS AND LIQUIDITY RISK
The fundamental role of banks typically involves the transfor- mation of liquid deposit liabilities into illiquid assets such as loans; this makes banks inherently vulnerable to liquidity risk.
Stocks of small and mid-cap companies have high market liquidity risk, as stated above. This is because buyers are uncertain of their potential growth in the future and hence, are unwilling to purchase such securities in fear of incurring losses in the long term.
Illiquidity is the opposite of liquidity. Illiquidity occurs when a security or other asset that cannot easily and quickly be sold or exchanged for cash without a substantial loss in value.
A company that has assets it can easily sell or cash reserves that it can draw from to pay its bills generally has a low liquidity risk. On the other hand, a company that may be forced to sell assets at a low price to cover day-to-day cash flow needs or debts has a higher liquidity risk.
Liquidity in finance by the book is how quickly any asset can be changed in to hard cash. Therefore, any account having only cash can be said as the most liquid. For instance, a checking or a saving account could be considered the most liquid accounts.
Banks create money when they lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend a fraction of it.
How do banks lose liquidity?
If a bank is suddenly faced with an unexpected outflow of money through large withdrawals, credit disbursements, or market instabilities it may become significantly less liquid. It may also be exposed to risk if for example, any markets it depends on are subject to their own loss of liquidity.
The LCR is calculated by dividing a bank's high-quality liquid assets by its total net cash flows, over a 30-day stress period. The high-quality liquid assets include only those with a high potential to be converted easily and quickly into cash.
Banks transform liquid liabilities (deposits) into illiquid claims (loans). This basic in- termediation role of banks relies on a maturity mismatch between assets and liabilities, making them exposed to bank runs or, more generally, to funding liquidity risk (Diamond and Dybvig, 1983).
the property of flowing easily. synonyms: fluidity, fluidness, liquidness, runniness.
For example, cash is the most liquid asset because it can convert easily and quickly compared to other investments. On the other hand, intangible assets like buildings or machinery are less liquid in terms of the liquidity spectrum.