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What is 'Liquidity Risk'?

Liquidity risk is the risk that stems from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Liquidity risk is 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 to 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 improves, the home may sell above its listed price. However, if the owner needs cash quickly when the market is down, he may sell the home for less and lose money in 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 use 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 way to reduce the discrepancy between available cash and debt obligations.

Liquidity Risk in Financial Institutions

Financial institutions are also scrutinized to determine whether they can meet their debt obligations without realizing great losses. Institutions face strict compliance requirements and stress tests that indicate their financial stability.

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 periods of financial stress. 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 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 proposed ratio is in line with the international Basel standard created in 2015 and reduces banks’ vulnerability in the event of another financial crisis.

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