Liquidity Risk

What is Liquidity Risk?

Liquidity risk is the risk that a company or individual will not be able to meet short-term financial obligations due to the inability to convert assets into cash without incurring a loss. This most often occurs when assets (such as securities) cannot be sold for a reasonable price due to a lack of buyers, large price movements, or widening bid-ask spreads.

How Does Liquidity Risk Work?

Liquidity risk occurs when a business or individual holds an asset that they want to sell in order to meet financial obligations, but cannot do so without selling it below its market value. There are a number of reasons why this might happen:

Inefficient markets: Assets may not reflect their fair or true market value.
Limited cash flow: Some businesses have limited cash flow at times, affecting their ability to meet financial obligations.
Market structure: Markets can vary in depth, width, and size, which can directly affect the ability to sell an asset.
Asset type: Assets vary in liquidity, so the type of asset can affect the time it takes to sell. For example, marketable securities and inventory would be easier to sell than land or property. 
Urgency: The amount of time before a financial obligation is due can affect the business or individual’s ability to meet that obligation.
Market conditions: Both a lack of buyers and an abundance of sellers can limit a business or individual’s ability to sell an asset.

Example of Liquidity Risk

Company ABC is a trucking business that operates out of a large midwestern warehouse. Its margins are thin so it doesn’t hold much cash, but it has a second, unused warehouse that is valued at $250,000. It currently has 10 trucks that cost $100,000 each, and in order to meet the monthly commitments to its client, it relies on all of them being fully operational. 

On the way back from a delivery, one of the drivers gets into an accident and their truck is totaled. The company’s insurance provider is trying to deny the claim, so the company does not expect to receive a payout for at least four months (if at all). The company still needs to deliver on its monthly commitments, but cannot do so with only nine trucks. 

The company must now purchase a new truck for $100,000 or they risk losing their contract. They don’t have the cash on hand, so they must sell off their second warehouse in order to meet their obligations. However, there aren’t many buyers for the warehouse, so they are forced to sell it to the highest bidder at a loss or they will fail to meet their monthly commitment to their client and lose their contract. 

Since Company ABC cannot meet its financial obligations without incurring a loss from the sale of its asset, it is experiencing liquidity risk.

Types of Liquidity Risk

The general definition of liquidity risk comes from the combination of the two types of liquidity risk: market liquidity risk and funding liquidity risk.

Market Liquidity Risk

Market liquidity risk refers to the risk that an asset can not be sold on a market without incurring a loss.

Funding Liquidity Risk

Funding liquidity risk refers to the inability to meet financial obligations caused by a lack of funding.

How Is Liquidity Risk Measured?

The two types of liquidity risk are measured differently.

How is Market Liquidity Risk Measured?

Market liquidity risk is measured in three ways: depth, width, and resilience.

Depth

The depth of a market is a measure of the volume of securities being traded – and the effect that orders have on market price:

• If a market is “deep”, there are many shares being traded. A large order would not have a significant effect on the market price. 
• If a market is “shallow” there are fewer shares being traded. A large order would have a significant effect on the market price.

Width

The width of a market refers to the bid-ask spread, which is the difference between the offer price and the asking price of an asset:

• If the gap is “wide”, there is a big difference between the price that sellers are asking and the price buyers are willing to pay. It is more difficult to complete a transaction. 
• If the gap is “narrow”, there is a small difference between the price sellers are asking and the price buyers are willing to pay. It is easier to complete a transaction.

Resilience

The resilience of a market refers to the speed at which prices return to previous levels following a large transaction.

How is Funding Liquidity Risk Measured?

Funding liquidity risk can be measured using two liquidity ratios: the current ratio and the quick ratio:

Current Ratio

This is a measure of a company's ability to pay its current liabilities using its current assets. It is calculated by dividing current assets by current liabilities. 

A value above “1” indicates that the company owns more short term assets than short-term liabilities and is therefore able to meet its short-term obligations. A value below “1” indicates that the company has more current liabilities than current assets and may struggle to meet financial obligations.

Quick ratio

This is a measure of how well a company can meet its short-term financial obligations by converting short-term marketable assets into the cash needed to cover short-term liabilities. It is calculated by dividing the sum of cash, marketable securities, and accounts receivable by current liabilities. 

A value above “1” indicates a strong ability to cover short-term liabilities, while a value below “1” indicates that it doesn't have enough liquid assets to cover current liabilities.

Liquidity Risk in Banks

Banks operate by accepting deposits from customers and using those funds to issue loans (e.g. mortgages, personal loans, student loans) to other customers. Deposits received are considered liabilities (since the funds must be accessible to customers) while loans issued are considered assets (since the borrowed funds are owed back to the bank). 

Furthermore, banks are only required to keep a small percentage of their total deposits as cash on hand (the reserve requirement). This means that they are free to invest the majority of their money into less liquid assets, typically, more loans. The fundamental nature of commercial banking involves the conversion of liquid liabilities (deposits) into illiquid assets (e.g. loans, bonds, other securities), which creates an inherent liquidity risk.

Liquidity Risk in Investing

All investments have liquidity risk, though some have more than others. Companies and individuals must take this risk into account when establishing business plans, purchasing assets, or making investments to ensure that they can meet their financial obligations. Otherwise, they run the risk of owing late fees, requiring additional funding from high-interest loans, becoming insolvent, or even going bankrupt. 

In order to reduce exposure to these risks, consideration should be given to factors (such as type of asset, current and future liabilities, cash flow, operating expenses, and risk tolerance).

Liquidity Risk Management

Liquidity risk is an important consideration for most companies and investors. While it is difficult to avoid altogether, there are ways it can be managed. 

The first step in liquidity risk management is identifying which investments have high liquidity risk and which investments have low liquidity risk.

Which Investments Have the Highest Liquidity Risk?

Investments that have the highest liquidity risk are more difficult to sell without taking a loss. Examples of investments with high liquidity risk include:

• Fixed assets (e.g. land, equipment, property)
• Real estate
• Certificates of deposit
• Art
• Vehicles
• Issuing long-term loans (e.g. mortgages)
• Infrequently-traded stocks

Which Investments Have the Lowest Liquidity Risk?

Investments that have the lowest liquidity risk are highly liquid and therefore easier to sell without taking a loss. Examples of investments with low liquidity risk include:

• Bonds
• Treasury bills
• Cash and cash equivalents
• Frequently-traded stocks
• Mutual funds
• Money market funds

How Can Liquidity Risk Be Managed?

There are a number of ways that banks, companies, and investors can manage their exposure to liquidity risk:

Forecasting Cash Flow

Cash flow forecasting estimates the amount of cash businesses or individuals will have on hand in the future, which can help them better manage their finances.

Comparing Assets and Liabilities

By comparing assets and liabilities, businesses can determine how much cash they could generate on short notice and how much they might owe.

Creating a Buffer Between Earnings and Expenses

A large gap between the amount of cash coming in and going out can make it easier to cover unexpected expenses.

Short-term Liquid Asset Investment Over Long-term Illiquid Assets

Short-term assets are generally much easier to sell than long-term assets. By holding liquid assets before purchasing illiquid ones, businesses and investors can more easily generate cash without incurring major losses.

Analyzing Financial Ratios

Analyzing financial and liquidity ratios can help identify and limit exposure to liquidity risk.

Reducing Leverage

Taking on too much debt can be a major source of liquidity risk. By reducing leverage, companies and individuals can shrink the gap between the amount they have and the amount they owe. This effectively reduces their liquidity risk.

Conducting Stress Tests

Simulations or other analyses can identify risk areas in the event of an economic shock. Using this information, the company or individual can develop processes and safeguards to mitigate risk.

Diversifying Investments

Diversifying a portfolio can help limit your exposure to risk and loss in the event that one of the investments loses value or can’t be sold quickly enough.

Gauging Potential Markets

Trying to sell an asset on short notice can be problematic if there is a lack of buyers, an abundance of sellers, or other undesirable market conditions. By analyzing potential markets in advance, sellers can get a better idea of how long it could take to sell an asset, as well as the possible selling price.

Why Liquidity Risk is Important to Understand

Liquidity risk can help companies and investors manage their investments, holdings, and operations to ensure that they are always able to meet financial obligations. Without it, they may purchase assets that cannot be sold without incurring a loss. They may fail to pay bills, which could eventually lead to insolvency or other financial distress.