If you’re in the financial industry, you’ve likely heard of liquidity risk. Investors, managers, and creditors, as just a few examples, often use liquidity measurement ratios to decipher the level of risk within an organisation and if it is worth investing in or working with. For this reason, you need to have a solid grasp of liquidity risk.
Liquidity risk is an important aspect to consider when you are in the financial industry. We are going to take a deep dive into liquidity risk, what it is, what contributes to it, and how to reduce the risk through various management forms.
Let’s take a look.
What is liquidity risk?
Liquidity risk is, essentially, the risk that a financial institution may not have enough money to meet all its obligations. You’ve likely heard of this happening before. There are many reasons that it can happen, for example, a sudden increase in withdrawals, or if the institution couldn’t sell assets off quickly enough to raise the necessary amount of money.
Liquidity risk is to be avoided at all times - very often it can cause financial institutions to become insolvent. Actually, when a financial institution faces insolvency, the financial system as a whole can be shaken. We have seen this with incredibly notorious banking crashes, for instance.
What can cause liquidity risk?
There are numerous factors that can contribute to liquidity risk, these include:
Interest rate levels. In particular, when interest rates rise, it can be incredibly expensive for financial institutions to raise cash. This can increase the risk of liquidity. This one is at the forefront of concerns at the moment with the cost of living crisis looming.
The financial institution's assets and liabilities. When assets are easy to sell quickly (think government bonds or cash), they are considered to be liquid. Some assets are considered much more difficult to sell (such as real estate). These are considered to be illiquid.
Economic activity levels. There is very often an increase in withdrawals from financial institutions when the economy is weak. This can very easily increase liquidity risk.
How can financial institutions manage liquidity risk?
Liquidity risk management is essential for financial institutions, and is, actually, one of the main aspects of risk management in this industry. Financial institutions need to carefully manage their liquidity to protect themselves from financial and reputational damage. Liquidity crises cause incalculable damage to the financial industry.
There are multiple ways that financial institutions can manage liquidity risk, reducing the potential of insolvency. These are:
Holding liquid assets, and a sufficient number of them, too. This includes cash and government bonds. Avoiding assets such as real estate is a safe choice, too.
Obtaining lines of credit from other financial institutions. This props you up if you ever find yourself in certain problems.
Entering into repurchase agreements (repos). These are short-term loans that are prominently used to raise money.
Hedge against interest rate risk by using derivatives.
What else can financial institutions do to manage their liquidity risk?
There are other additional tips you should follow to manage liquidity in financial institutions.
Monitor liquidity regularly. Don’t let it sneak up on you. This means you should be tracking everything from interest rates and economic activity to your balance sheet. Don’t let anything go amiss.
Have a very clear understanding of your specific institution’s liquidity profile. Every institution looks different. You should know which assets are liquid or illiquid. You should also know how much cash is on hand, and how quickly they can be sold.
Implement risk management controls to mitigate liquidity risk.
A great way to do this is by setting limits on how many illiquid assets can be held or requiring approval for large withdrawals. These help prevent problems further down the line.
Have a contingency plan in order, just in case. If you find yourself in liquidity problems, it’s so helpful to have a plan ready. This could be done by having a line of credit in place or entering into repurchase agreements.
We hope this helped you not only understand what liquidity risk is in the finance sector but also how to manage it. Following these tips and tricks can help you to protect yourself from the damage that comes with a liquidity crisis.