What is Liquidity Risk?
Liquidity is an organisation, business, or even an individual's ability to pay off their debts without suffering severe losses. In comparison, liquidity risk derives from the lack of marketability of an investment that cannot be acquired or sold fast enough to avoid or mitigate a loss. Typically, it is expressed in substantial bid-ask spreads or significant price changes.
Analysing Liquidity Risk
The general rule of thumb is that the smaller the size of the security, or its issuer, the higher the risk of liquidity. Declines in stock prices and other stocks have prompted many investors to sell their assets at any cost in the wake of the 9/11 attacks, as well as in the global credit crisis from 2007 to 2008.
Liquidity risk occurs when individual investors, corporations, or financial institutions are unable to meet their short-term debt obligations. Because of a lack of buyers or a competitive market, the investor or company may not turn an asset into cash without giving up capital and profits.
Investors and executives use metric ratios of uncertainty when determining the level of risk within an enterprise. They often compare short term liabilities with the liquid assets listed on the financial statements of a company. If a company has an unreasonable liquidity risk, it must sell its assets, generate extra revenue, or find another way to minimise the gap between available cash and debt.
Liquidity Risk in Financial Institutions
Financial institutions are primarily dependent on borrowed capital, and they are typically scrutinised to decide whether they can satisfy their debt obligations without experiencing significant losses that could be catastrophic. Therefore, institutions face strict requirements for compliance and stress tests to measure their financial stability.
