What is liquidity risk in financial markets? Here’s what you should know!

Are you an investor in the financial market? If yes, liquidity must be a familiar term to you. It is one of the most crucial aspects investors consider while making investment choices. The liquidity of an asset significantly impacts its value.

So, in today’s article, let’s understand thoroughly what liquidity means and the risks involved when an asset is not liquid enough.

What is liquidity risk?

Before understanding the risk associated with it, let’s learn what liquidity means. Liquidity suggests an asset’s potential to transform into cash without incurring high additional expenses. 

Liquidity risk refers to the risk of an asset’s inefficiency to quickly convert into cash. Due to such inability, the asset owner may face challenges meeting certain obligations.

Liquidity risk can affect individuals as well as corporations. The lack of liquidity can be due to a variety of reasons, including the unpreparedness of the asset owner or a change in the economic scenario.

Types of liquidity risks

Liquidity risks are of two types:

• Market liquidity risk

Market liquidity risk is where an entity finds it challenging to buy or sell an asset in the market at prevailing prices. It usually happens because the market for the asset is not deep enough, suggesting that it does not have sufficient demand at the moment. The lack of demand could be due to the unawareness of consumers, low product performance, etc.

• Funding liquidity risk

Funding liquidity risk is where an entity finds it difficult to arrange funds to cater to its financial obligations. The entity’s inability to raise funds may be due to multiple reasons, including the borrower’s creditworthiness, lack of preparedness for unforeseen events, market uncertainties, etc.

Liquidity risk example

To understand the concept better, let’s consider a liquidity risk example. A large-scale company with high networth and revenue has most of its funds invested in fixed capital, such as machinery and infrastructure. In this case, the company is still exposed to high liquidity risk since machinery and infrastructure cannot be easily converted into cash, and they also undergo depreciation.

Impact of liquidity risks

Liquidity risk affects various entities like corporations, financial institutions and even individuals.

For banks

The impact of liquidity risk for banks deals with financial institutions not being able to meet their commitments, such as repaying deposits to customers. The fundamental nature of the operations of banks includes accepting deposits and lending loans to customers. When there is a discrepancy between the maturity date of deposits and loans, banks struggle to meet their commitments when multiple customers try to withdraw funds at the same time.

For corporations

Corporations, especially those manufacturing products, incur heavy expenses while sourcing the required machinery for their factory set-up. Debt is a common source that companies rely on while arranging funds for such capital expenses. 

Liquidity risk is when companies fail to repay such debts because they do not have enough cash in their reserves. The reasons for this can be fluctuating demand for products, bad debts from customers, etc. Such risk and the non-payment of its liabilities impact the firm’s goodwill and creditworthiness to a large extent, finally bringing down the share price.

For investors

From an individual’s perspective, liquidity risk is a situation where the person does not have sufficient funds to meet urgent needs, such as medical expenses, overdue bills, etc.

Talking about investors in particular, liquidity is where investors find it challenging to sell their assets, like stocks, bonds, real estate, etc., in the market at current prices.

How to mitigate liquidity risk?

Different entities use different strategies for liquidity risk management.

Banks:

• Banks must try to maintain a balanced portfolio which has a sufficient amount of liquid assets.
• Banks must use liquidity ratios, like liquidity coverage ratios, to analyse their current positions. They must also deploy concepts like stress tests to understand the bank’s efficiency in handling market uncertainties.
• Banks must try to diversify their sources for raising funds instead of relying only on deposits while repaying their customers.

Corporations:

• Corporations must explore the option of credit lines that remain open even when they pay the outstanding debt. Such options allow quick and easy access to cash.
• Budgeting and forecasting must be a regular and integral part of the company’s management.
• Cash reserves are crucial. They help companies take care of unforeseen expenses.

Individuals:

• Investors must thoroughly analyse their stocks using various liquidity ratios before investing in them.
• Investors must have an investment portfolio with instruments having varied maturities.
• Individuals must maintain emergency funds to handle urgent expenses.

Bottomline

Liquidity risk is a severe threat to entities that can push them into debt traps. It is a situation where entities are unable to meet their financial commitments.

However, the danger can be controlled to a large extent if they properly plan for it and apply the exclusive strategies available for different entities, to save themselves from the clutch liquidity risk.

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