Understanding Liquidity Risk – What Is It & its Types?

What Is Liquidity Risk?

Liquidity is the ease with which any asset can be sold and converted to cash. Thus ‘liquidity risk’ is the risk of not being able to make this conversion easily. Liquidity risk can put a company in a precarious position. If it is unable to sell its assets or investments fast enough to raise cash for debt repayments, it is said to be facing liquidity risk and can get in trouble for failing its obligation.

Liquidity risk is inversely proportional to the size of the asset issue or its issuer. For example, if a lesser-known company goes public, it may not attract enough investors and in turn fail to garner the funds it seeks to raise. Hence, investors and shareholders use liquidity ratios to measure how capable a company is to repay its short-term debt. Highly leveraged companies commonly undergo this scrutiny for the same purpose.

Types of Liquidity Risk

There are essentially three types of liquidity risks:

1. Central Bank Liquidity Risk

It is a common misconception that central banks cannot be illiquid due to the widespread belief that they will always provide cash when required. While it is true that the central bank always strives to strike a balance between the supply and demand of currency by tweaking interest rates, there are exceptional situations too. For instance, when the domestic currency of the nation itself loses its demand, the need for more supply simply disappears. This can only happen when there is hyperinflation or an exchange rate crisis.

This happened to Zimbabwe in 2008 when the

inflation rose to an estimated at 79.6 billion percent per month, and the YoY inflation rate touched 89.7 sextillion percent! The currency’s value went into freefall and at its worst, 1 USD became equivalent to 2,62,19,84,228 Zimbabwean Dollars! This extraordinary situation led to the complete discontinuation of its currency in 2008 and it migrated to using USD.

2. Funding Liquidity Risk

This type of liquidity risk arises from a financial institution’s inability to pay off its liabilities when they are due. Companies normally fulfil their short-term debt obligations from their operating cash flow. However, when a firm fails to do so, it can become a cause for disrepute among its investors, shareholders and even the broader market. Share prices can also plummet at such times and the credit rating of the organisation also falls sharply. This makes it even more difficult to raise funds in the future through bank loans.

Funding liquidity risk can be measured using various key ratios such as:

• Current Ratio – measures if a company’s current assets are sufficient to cover its current liabilities.

• Quick Ratio – measures the amount of liquid assets at the company’s disposal to cover its current liabilities.

• Interest Coverage Ratio – measures whether a company’s interest payments can be managed within its EBITDA.

3. Market Liquidity Risk

This is an inherent risk in the market caused by price fluctuations arising out of different trading patterns in different securities. A high level of market liquidity risk means that there are very few buyers for a security and demand is very low. This means that the seller cannot easily convert their stocks to cash. Such a demand drop may occur because:

• Volatility is high & investors are choosing to avoid price fluctuations.
• An economic crisis or recession has led to less expenditure among the masses.
• The company has fallen into disrepute.
• Global economic conditions are on a downturn.

These factors are likely to cause share prices to fall due to less buying activity and reduced demand. This in turn makes potential investors uncertain of the company’s performance capabilities and they choose to steer clear of its stock. This situation can be observed in the low volume numbers on your trading terminal. Moreover, a large number of sell orders and much fewer buy orders confirm the same.

The bid-ask spread is a very good indicator of market liquidity risk. When you subtract the ‘ask price’ (price at which the seller wants to liquidate) from the ‘bid price (price at which the buyer wants to purchase), the difference is the ‘bid-ask spread.’ A large spread shows that the sellers and buyers are in disagreement on the price point and thus a lower trading volume will show.

Liquidity Risk in Banks

Banks are not just lenders, but also borrowers themselves. They borrow from each other as well as the central bank to manage their deposits and invest the surplus. Since borrowing is a regular part of their business, they are also subjected to stringent scrutiny to ascertain in time if they are capable of repaying their debts without taking on financial damage. After the 2008 financial crisis, the Reserve Bank of India (RBI) published risk management principles derived from the “Principles for Sound Liquidity Risk Management and Supervision,” which was published by the Basel Committee on Banking Supervision (BCBS) in September 2008. The document elaborated on all aspects including management of risk, governance, and its measurement. The Basel Accord III, along with other international agreements, serves as the regulatory framework for maintaining control over trading liquidity risk in stock markets at a macroeconomic level.

Liquidity Risk in Businesses

Fund managers as well as investors resort to the above-mentioned liquidity ratios to gauge the financial soundness of a company when it comes to repaying debts. For the same purpose, the firm’s short-term as well as long-term liabilities are closely looked at and compared with the same in assets. A very high debt obligation can imply that some assets will have to be sold to meet the same.

Conclusion

Investors must exercise caution when investing in securities. Today, even trading terminals are programmed to warn you if you are investing in an illiquid stock. As we always emphasise, research is key and will keep you ahead of the curve when it comes to identifying a mismatch between demand and supply, which is essentially where liquidity risk stems from.

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