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Liquidity Risk

Liquidity management is a major area for financial managers and senior executives, since a firm’s survival is directly dependent on the profitability and the ability of the firm to generate enough cash to support its operations and honour its financial obligations. Among these there are important commitments such as paying employee salaries, paying suppliers or returning funds to clients, should they choose to withdraw.

Liquidity management is specially important for banks as recent history showed the world the great dangers of systemic risk, when a big bank runs into liquidity problems and that affects directly the whole financial and economic system.

Asset managers, for example, also have to manage very closely their liquidity as these firms manage money on behalf of clients, where individual funds will have different requirements. Brokerage firms also have exposure to funding liquidity risk, because a majority of their assets might be financed by short-term borrowing from wholesale sources.

It’s important to understand the context in which the term “Liquidity” is many times used, all of them related to the availability and usage of cash:

  • A given firm is said to have liquidity if it can quickly have access to cash to fulfil its financial obligations
  • A financial market is considered liquid if the assets being traded in it can quickly be traded i.e. many bid and ask offers (with a low spread bid/ask) and low volatility
  • A financial asset is said to be liquid if it trades in a liquid market – therefore easy to trade from and converted into cash

There are thousands of online references to the Liquidity Risk definition. Below are some of the most relevant ones.

The European Central Bank (ECB) published in March 2009 a working paper series that contains the several definitions of liquidity types: central bank liquidity, market liquidity and funding liquidity. Click here to access and download this paper.

The Bank for International Settlements (BIS) published in 2008 the “Principles for Sound Liquidity Risk Management and Supervision” which is available in the BIS website. BIS defines liquidity as:

Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole. Virtually every financial transaction or commitment has implications for a bank’s liquidity. Effective liquidity risk management helps ensure a bank’s ability to meet cash flow obligations, which are uncertain as they are affected by external events and other agents’ behaviour. Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial market developments in the past decade have increased the complexity of liquidity risk and its management.

Investopedia also defines and illustrates liquidity risk. Click here to access “Understanding Liquidity Risk“.

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