What is liquidity risk management?
Liquidity Risk Management
Liquidity risk is the risk of loss resulting from the inability to meet payment obligations in full and on time when they become due. Liquidity risk is inherent to the Bank's business and results from the mismatch in maturities between assets and liabilities.
Liquidity risk professionals monitor cash flows, analyse funding sources, and develop strategies to maintain sufficient liquidity. They assess potential liquidity stress scenarios, implement liquidity risk management frameworks, and establish contingency plans to mitigate liquidity risks.
Liquidity management is the proactive process of ensuring a company has the cash on hand to meet its financial obligations as they come due. It is a critical component of financial performance as it directly impacts a company's working capital.
It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.
A liquidity risk example in banks is a decline in deposits or rise in withdrawals (which are liabilities for the bank). As a result, the bank is unable to generate enough cash to meet these obligations. This was dramatically illustrated by the global financial crisis of 2008-2009.
The three main types are central bank liquidity, market liquidity and funding liquidity.
Finance teams use liquidity management to strategically move funds where they are needed. For example, a CFO may review the balance sheet and see that funds currently tied up in one area can be moved to a critical short-term need to maintain day-to-day operations.
Liquidity management tools—such as pricing arrangements, notice periods and suspension of redemption rights—can help alleviate the liquidity risk generated by investment funds.
A bank is responsible for the sound management of liquidity risk.
How is liquidity management done?
Some effective strategies for cash and liquidity management include regular cash flow forecasting, efficient receivables and payables management, maintaining a liquidity buffer for unexpected expenses, investing excess cash in easily liquidable assets, and using technology solutions to gain real-time insights into cash ...
As liquidity management requires total visibility into financial data, it helps companies create more accurate scenario analysis and cash forecasting. Thus, it guides important financial decisions, such as whether to invest in expansion or new projects or whether a lender will approve a loan for your organization.
Cash is the most liquid asset, followed by cash equivalents, which are things like money market accounts, certificates of deposit (CDs), or time deposits. Marketable securities, such as stocks and bonds listed on exchanges, are often very liquid and can be sold quickly via a broker.
Liquidity Risk Indicators: Low levels of cash reserves, high dependency on short-term funding, or a high ratio of loans to deposits can hint at liquidity risk. Such indicators help banks ensure they can meet their financial obligations as they come due.
Stocks of small and mid-cap companies have high market liquidity risk, as stated above. This is because buyers are uncertain of their potential growth in the future and hence, are unwilling to purchase such securities in fear of incurring losses in the long term.
Credit risk is when companies give their customers a line of credit; also, a company's risk of not having enough funds to pay its bills. Liquidity risk refers to how easily a company can convert its assets into cash if it needs funds; it also refers to its daily cash flow.
Liquidity risks are measured by way of the current ratio. It takes all of the entity's current assets and divides them by its current liabilities.
Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.
Liquidity risk reflects the possibility an institution will be unable to obtain funds, such as customer deposits or borrowed funds, at a reasonable price or within a necessary period to meet its financial obligations.
Liability side liquidity risk arises from transactions whereby a creditor, depositor, or other claim holder demands cash in exchange for the claim. The withdrawal of funds from a bank is an example of such a transaction. Another type of asset side liquidity risk arises from the FI's investment portfolio.
What causes poor liquidity?
- Inefficient cash flow management. ...
- Lack of funding. ...
- Unplanned capital expenditures. ...
- Economic disruptions. ...
- Profit crisis.
High levels of liquidity arise when there is a significant level of trading activity and when there is both high supply and demand for an asset, as it is easier to find a buyer or seller. If there are only a few market participants, trading infrequently, it is said to be an illiquid market or to have low liquidity.
First, banks can obtain liquidity through the money market. They can do so either by borrowing additional funds from other market participants, or by reducing their own lending activity. Since both actions raise liquidity, we focus on net lending to the financial sector (loans minus deposits).
Liquidity risk refers to how a bank's inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM).
- Increase revenue. Increasing revenue is not always about raising prices. ...
- Control overhead expenses. ...
- Sell redundant assets. ...
- Change your payment cycle. ...
- Enhance accounts receivable. ...
- Utilise financing tactics. ...
- Revisit your debt obligations. ...
- Automate and go digital.
