What Is Liquidity Risk?
Liquidity risk is the potential for investment loss when an asset or financial instrument cannot be traded within a given timeframe. For a financial institution, a liquidity shortfall could damage not only its finances but also its reputation. Occasionally, liquidity risk could be impacted by the large or concentrated exposure in the portfolio.
This kind of risk can be classified into two types:
- Funding liquidity risk – the loss incurred when a financial institution is unable to settle its obligations with immediacy
- Market liquidity risk – the expected loss incurred when trading an asset for cash
Effective techniques for managing liquidity risk include:
- Building customized asset-liability management models
- Designing and pricing derivatives to hedge risk
- Performing market impact studies
- Implementing Basel II/III compliant risk systems
- Performing scenario analysis and stress testing to assess risk exposure from cash flow variations
- Monitoring key ratios, such as liquidity coverage ratio, net stable funding ratio (NSFR), and concentration indices