What Is Liquidity Risk?
Liquidity is the ability of a firm, company, or even an individual to pay its debts without suffering catastrophic losses. Conversely, liquidity risk stems from the lack of marketability of an investment that can't be bought or sold quickly enough to prevent or minimize a loss. It's typically reflected in unusually wide bid-ask spreads or large price movements.
- Liquidity is the ability of a firm, company, or even an individual to pay its debts without suffering catastrophic losses.
- Investors, managers, and creditors use liquidity measurement ratios when deciding the level of risk within an organization.
- If an individual investor, business, or financial institution cannot meet its short-term debt obligations, it is experiencing liquidity risk.
Liquidity Risk Explained
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 motivated many investors to sell their holdings at any price in the aftermath of the 9/11 attacks, as well as during the 2007 to 2008 global credit crisis. This rush to the exits caused widening bid-ask spreads and large price declines, which further contributed to market illiquidity.
Liquidity risk occurs when an individual investor, business, or financial institution cannot meet its short-term debt obligations. The investor or entity might be unable to convert an asset into cash without giving up capital and income due to a lack of buyers or an inefficient market.
Liquidity Risk in Companies
Investors, managers, and creditors use liquidity measurement ratios when deciding the level of risk within an organization. They often compare short-term liabilities and the liquid assets listed on a company’s financial statements. If a business has too much liquidity risk, it must sell its assets, bring in additional revenue, or find another way to reduce the discrepancy between available cash and its debt obligations.
Liquidity Risk in Financial Institutions
Financial institutions depend upon borrowed money to a considerable extent, so they're commonly scrutinized to determine whether they can meet their debt obligations without realizing great losses, which could be catastrophic. Institutions, therefore, face strict compliance requirements and stress tests to measure their financial stability.
The Federal Deposit Insurance Corporation (FDIC) released a proposal in April 2016 that created a net stable funding ratio. It was intended to help increase banks’ liquidity during periods of financial stress. The ratio indicates whether banks own enough high-quality assets that can be easily converted into cash within one year rather than within the current 30-day limit. Banks 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 problems. The FDIC ratio is in line with the international Basel standard, created in 2015, and it reduces banks’ vulnerability in the event of another financial crisis.
A Real-World Example
A $500,000 home might have no buyer when the real estate market is down, but the home might sell above its listed price when the market improves. The owner might sell the home for less and lose money in the transaction if he needs cash quickly so he must sell while the market is down.
Investors should consider whether they can convert their short-term debt obligations into cash before investing in long-term illiquid assets to hedge against liquidity risk.