What Is Liquidity Risk and How Does It Affect You?

What Is Liquidity Risk and How Does It Affect You?

Liquidity refers to a company's or an individual's capacity to pay its debts without incurring significant losses. Liquidity risk, on the other hand, arises from an investment's inability to be acquired or sold quickly enough to avoid or reduce a loss. It frequently manifests itself in exceptionally broad bid-ask spreads or big price swings.

Important Takeaways

• Liquidity refers to a company's or an individual's capacity to pay its debts without incurring significant losses.
• Liquidity measurement ratios are used by investors, managers, and creditors to determine the level of risk in a company.
• Liquidity risk occurs when an individual investor, corporation, or financial institution is unable to satisfy its short-term loan obligations.

Liquidity Risk: What You Need to Know

The general consensus is that the smaller the securities or issuer, the greater the liquidity risk. Following the 9/11 attacks, as well as during the 2007–2008 global credit crisis, drops in the value of stocks and other securities prompted many investors to sell their holdings at any price. Market illiquidity was exacerbated by the rush to the exits, which resulted in widening bid-ask gaps and huge price drops.

When an individual investor, a corporation, or a financial institution cannot satisfy its short-term loan obligations, liquidity risk arises. Due to a shortage of buyers or an inefficient market, the investor or corporation may be unable to turn an asset into cash without giving up capital and revenue.

Financial Institutions' Liquidity Risk

Financial institutions rely heavily on borrowed funds, so they're frequently evaluated to see if they can satisfy their debt obligations without incurring significant losses, which might be disastrous. As a result, institutions are subjected to stringent compliance requirements and stress tests in order to assess their financial viability.

In April 2016, the Federal Deposit Insurance Corporation (FDIC) proposed establishing a net stable funding ratio. Its purpose was to help banks improve their liquidity during times of financial stress. The ratio reflects if banks have sufficient high-quality assets that can be converted into cash in a year's time. Short-term finance, which is more volatile, is used less by banks.

Due to liquidity challenges, many large banks failed or faced insolvency during the 2008 financial crisis. The FDIC ratio adheres to the international Basel standard, which was established in 2015 and decreases banks' exposure in the case of another financial crisis.

Companies' Liquidity Risk

Liquidity measurement ratios are used by investors, managers, and creditors to determine the level of risk in a company. They frequently compare a company's short-term liabilities and liquid assets on its financial statements.

If a company's liquidity risk is too high, it must sell assets, generate new revenue, or find another strategy to close the gap between available cash and debt commitments.

Current Ratio

Example from the Real World

When the real estate market is depressed, a $500,000 home may go unsold, but when the market improves, the home may sell for more than its advertised price. If the owners need cash soon and must sell when the market is low, they may sell the home for less and lose money in the deal.

Before investing in long-term illiquid assets to hedge against liquidity risk, investors should assess whether they can convert their short-term debt obligations into cash.