What is 'Liquidity Risk'
Liquidity risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. With liquidity risk, typically reflected in unusually wide bid-ask spreads or large price movements, the rule of thumb is that the smaller the size of the security or its issuer, the larger the liquidity risk. Drops in the value of stocks and other securities in the aftermath of the 9/11 attacks and the 2007-2008 global credit crisis motivated many investors to sell their holdings at any price, causing widening bid-ask spreads and large price declines, which further contributed to market illiquidity.
BREAKING DOWN 'Liquidity Risk'Liquidity risk occurs when an individual investor, business or financial institution cannot meet short-term debt obligations. The investor or entity may be unable to convert an asset into cash without giving up capital and/or income due to a lack of buyers or an inefficient market. For example, a $500,000 home may have no buyer when the real estate market is down. When the market goes up, the home may sell above its list price. However, if the owner needs cash quickly when the market is down, he may sell the home for less and lose money on the transaction. Due to liquidity risk, investors should consider whether they can cover their short-term debt obligations into cash before investing in long-term illiquid assets.
Liquidity Risk in Companies
Investors, managers and creditors utilize liquidity measurement ratios when deciding the level of liquidity risk within an organization. They often compare short-term liabilities and liquid assets listed on the company’s financial statements. If a business has too much liquidity risk, it must sell assets, bring in additional revenue or find another method of shrinking the difference between available cash and debt obligations.
Liquidity Risk in Financial Institutions
Financial institutions are also scrutinized as to whether they can meet their debt obligations without realizing great losses. The institutions face heavy compliance issues and stress tests for remaining economically stable.
In April 2016, the Federal Deposit Insurance Corporation (FDIC) released a proposal creating a net stable funding ratio that would help increase banks’ liquidity during financially stressful times. The ratio indicates whether banks own enough high-quality assets that can easily be converted into cash within one year rather than within the current 30-day limit. Banks would rely less on short-term funding, which tends to be more volatile.
During the 2008 financial crisis, many big banks failed or faced insolvency issues due to liquidity issues. The proposed ratio is in line with the international Basel standard created in 2015 and would reduce banks’ vulnerability in case of another financial crisis.