UNDERSTANDING LIQUIDITY RISK: DEFINITION, CAUSES, CONSEQUENCES

FOR A BUSINESS, LIQUIDITY RISK DESCRIBES A POTENTIAL INABILITY TO ADDRESS SHORT-TERM CASH OUTFLOW. FOR INVESTORS, ON THE OTHER HAND, IT DESCRIBES THE RISK OF NOT FINDING COUNTERPARTIES WILLING TO PAY THE APPLICABLE MARKET PRICES FOR THEIR TRANSACTIONS.

Find out about liquidity risk and how to optimise your business’s or your portfolios’ exposure to liquidity risk in our comprehensive summary.

WHAT IS LIQUIDITY RISK?

Liquidity Risk Faced by Businesses

By definition, liquidity risk describes the risk that a business will be unable to meet its short-term financial commitments (paying back a bank loan, paying a service provider, salaries, tax debt…).

Therefore, accounting liquidity risk usually describes the risk of cashflow issues, which is the inability to meet one’s short-term (less than one year) financial commitments. Such issues may result in payment defaults on the part of the business in question, or even in bankruptcy.

Finally, liquidity risk could also mean that a company has difficulty “liquidating” very short-term financial investments. Businesses that possess illiquid assets (with low trading volumes) may find themselves unable to resell their positions at market value due to a lack of available counterparties.

Liquidity Risk Faced by Investors

By definition, investor liquidity risk represents any potential difficulty that may arise when selling positions on the market.

An investor who wishes to sell their assets may indeed struggle to find a counterparty willing to purchase it at its full market value (a difficulty which is more pronounced as a position gets bigger and trading volumes get lower). The investor may therefore find themselves with no choice but to accept a low price simply to be able to liquidate their position more quickly.

In the worst-case scenario, liquidity risk could even translate into a total inability to sell a financial position due to a market that is either too narrow, or non-existent altogether.

Furthermore, trading suspensions may be issued for technical reasons or decided by financial centres due to any major events which could participate in liquidity risk for investors.

Liquidity Risk Faced by Banks

For a bank, liquidity risk is comprised of both business liquidity risk and investor liquidity risk (each being exacerbated by the very nature of banking). Yet it also includes a more specific risk in the case of their clients massively withdrawing their savings.

Widely dependent on the liquidity conditions of the interbank market for their short-term investment needs, banks are particularly exposed when the market or their clients lose their confidence.

To prevent an interbank market “freeze” and “bank run” phenomena (as observed during the 2008 crisis, for instance), new regulatory frameworks (including Basel III) were put in place to impose more prudence on the part of banking establishments.

In every currency area, the central bank is on the look-out, ready to inject large amounts of liquidity should the financial system undergo another crisis which could result in a financial meltdown.

WHAT IS THE CAUSE OF CORPORATE LIQUIDITY RISK?

For a business, liquidity risk typically comes from a lack of sufficient liquidity to cover lesser anticipated expenses.

Two main causes for corporate liquidity risk may be identified:

  • The absence of a sufficient “safety buffer” to cover overall expenses (the most unexpected ones in particular);
  • Difficulty finding necessary funding on the credit market or on financial markets.


Being able to measure a business’s liquidity is crucial to liquidity risk management. It makes it possible to ensure that short-term debt obligations will be adequately financed by the amount of cash available and, if necessary, by short-term positions that can be turned into liquidity quickly and easily.

Treasurers usually follow three ratios to assess short-term liquidity:

  • The general liquidity ratio (assets within one year / debts within one year);

  • Low liquidity ratio ([amounts due within one year] / debts within one year);

  • Quick ratio (availability / debts within one year).

It is worth noting that, unlike solvency risk (inability to repay a loan), liquidity risk does not only apply to struggling companies!

In the case of a business whose turnover is increasing rapidly, its working capital (WC) – the amount of money necessary to cover the gap between accounts receivable and supplier payables – is also likely to grow quickly and can greatly affect the net treasury, exposing the company to liquidity risk.

HOW TO APPLY THE PRINCIPLES OF LIQUIDITY RISK MANAGEMENT?

In order to reduce a company’s exposure to risk, more visibility may be gained on the cash position to anticipate liquidity risk.

To that end, companies can utilise a cash management solution aimed specifically at liquidity risk management to monitor present and future cash positions on a daily basis (the whole challenge being to anticipate cash inflow and outflow acutely to safeguard the right amount of liquidity to face any unexpected situation).

A company can also increase its equity capital to improve its financial resources. In order to do so, it could, for example, organise a seasoned equity offering to increase its own equity and improve its financial structure as well as the image of its balance sheet.

Sort term, companies may also resort to traditional bank funding, take advantage of their overdraft facility, or use factoring or leasing if necessary. In the most extreme cases, a business can also give up some of its fixed assets: selling these fixed assets generates a sizeable short-term source of funding and can boost the company’s liquidity ratios.

Finally, modifying a company’s cash conversion cycle may also prove necessary in order to minimise the gap between inflow and outflow and to improve treasury management. For example, through reducing the stock of finished goods, negotiating payment extensions with suppliers or reducing customer payment deadlines.

Such actions aim to reduce the need for working capital, to increase the outstanding amount available on a company’s current account, and to improve its overall financial health. In short, the goal is to improve the business’s self-funding abilities.

Proper liquidity risk management requires the right measuring and monitoring tools, as well as a professional approach. Utilising it to its full potential will give a company the advantage over the competition and ensure better financial sustainability.

 

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