Liquidity Risk

Liquidity risk is the challenge of meeting short-term financial obligations due to asset conversion constraints. Calculated via the current ratio (Total Current Assets / Total Current Liabilities), an increase from 0.5x to 1.0x over four years signals improving liquidity, enhancing the ability to cover debts without loss.
EXPLORE FUNDS
Liquidity Risk
EXPLORE FUNDS
3 min
19-June-2024

Liquidity risk arises when a financial asset can't be swiftly traded without impacting its price or when a bank may struggle to meet obligations without significant losses. It's managed by ensuring ample funds are available to fulfill demands. This risk encompasses short-term and structural funding imbalances, distinct from capital risk, which pertains to efficient cash access for enterprises.

What is Liquidity Risk?

Liquidity risk is a critical financial concept that pertains to the uncertainty of a party's ability to fulfill its financial obligations without incurring substantial losses. This risk arises when an entity, whether an individual, corporation, or financial institution, cannot easily convert assets into cash or secure necessary funding without a significant compromise in value. In the intricate web of global finance, liquidity risk is a pivotal concern that affects investment decisions, operational strategies, and ultimately, financial stability. It underscores the importance of having access to ready cash or easily liquidable assets to meet immediate and short-term obligations, ensuring that operations continue smoothly and financial commitments are honored on time. Understanding and managing liquidity risk is essential for maintaining solvency and fostering trust in the financial markets.

Example of liquidity risk

An example could be a real estate developer unable to sell properties due to a market downturn, thereby facing challenges in repaying construction loans. This scenario highlights both market and funding liquidity risks.

Also read - How to measure mutual funds risk

When does liquidity risk arise?

Liquidity risk arises from over-reliance on short-term funding sources or sudden cash flow disruptions. Unforeseen liquidity risks can be particularly stressful. Another concern is having a balance sheet overly concentrated in illiquid assets that are difficult to convert to cash quickly, exposing companies to funding liquidity risk or cash flow liquidity risk.

Market liquidity risk, also known as asset liquidity risk, refers to the difficulty in selling assets like property quickly due to their illiquidity. Liquidity depends on market conditions—having potential buyers enhances asset liquidity. Price volatility often reflects liquidity costs, especially in banking and securities trading, where liquid assets always have a market, but prices fluctuate.

In investing and banking contexts, the bid-ask spread serves as a key liquidity measure. It represents the transaction cost, or spread, between the price a buyer is willing to pay (bid) and the lowest price a seller accepts (ask).

Types of liquidity risk

Liquidity risk refers to the potential difficulty of converting assets into cash without significant loss in value. In the Indian context, where market volatility can be high, liquidity risk management becomes a critical concern for investors, businesses, and financial institutions. It encompasses the ability to meet cash flow needs or to sell assets quickly due to market conditions.

Market liquidity risk

Market liquidity risk management in India arises when an asset cannot be sold quickly in the market without impacting its price significantly. This is particularly relevant in less liquid markets or during periods of market stress where the demand for certain securities drops, making it hard to find buyers without reducing the price.

Funding liquidity risk

Funding liquidity risk involves the inability to obtain funds to meet cash flow needs. In India, where access to credit markets can sometimes be constrained, companies and financial institutions may face difficulties in raising funds quickly or economically.

Liquidity risk and banks

Banks in India are particularly exposed to liquidity risk due to the nature of their business—transforming short-term deposits into long-term loans. Maintaining sufficient liquidity to meet withdrawal demands while optimizing returns is a delicate balance that banks need to manage.

Liquidity risk and bank runs

Bank runs, where many depositors withdraw their money simultaneously fearing the bank's insolvency, exemplify extreme liquidity risk. Indian banks mitigate this risk by maintaining high liquidity, reassuring depositors, and sometimes relying on central bank support to meet demand.

Liquidity risk and corporations

Corporations in India face liquidity risk in meeting operational expenses or debt obligations during tight cash flow periods. Industries with high capital intensity or those experiencing cyclical sales are particularly vulnerable.

Also read - What is risk return trade off?

Why liquidity risk management is important

The events of 2020 highlighted how even previously successful businesses can face sudden cash shortages. To safeguard your business from financial disruptions due to supplier liquidity issues, it is crucial to identify, assess, and mitigate potential threats. Monitoring early warning signs of financial risks can prevent surprises like insolvency. Leveraging digital tools and AI-driven data systems helps detect and manage supplier liquidity risks effectively, ensuring data accuracy and reliability.

Establishing and utilising key performance indicators (KPIs) is essential to gauge solvency and anticipate market fluctuations affecting pricing. Evaluate the impact of product shortages or supplier financial instability on your operations and overall category performance. Real-time monitoring of liquidity risks enables swift identification of negative trends. Implement stress tests—including simulations and forecasts—to mitigate potential liquidity risk impacts. Develop contingency plans to manage adverse scenarios effectively.

How banks manage liquidity risk?

Indian banks manage liquidity risk through maintaining a portion of their assets in highly liquid forms, adhering to regulatory liquidity ratios, and having access to liquidity support from the Reserve Bank of India. Strategies also include diversifying funding sources and carefully planning cash flow schedules.

How corporations manage liquidity risk?

To manage liquidity risk, corporations maintain cash reserves, arrange for flexible credit lines, and manage receivables and payables effectively. They also often invest in liquid assets that can be quickly converted to cash if needed.

Also read - What is a risk profile?

How individuals can manage liquidity risk

Individuals can manage liquidity risk by diversifying their investment portfolios, keeping a portion in liquid assets like savings accounts or liquid mutual funds, and planning for emergency funds to cover unexpected expenses.

How does liquidity risk relate to market risk and credit risk?

Liquidity risk is intertwined with market and credit risk. Market downturns can lead to higher liquidity risk as assets become harder to sell. Credit risk impacts liquidity when borrowers default, affecting the lender’s cash flow and asset liquidity.

Can liquidity risk affect the broader economy?

Yes, liquidity risk can have broader economic implications. It can lead to fire sales, affect financial institutions' ability to lend, and trigger a loss of confidence, all of which can exacerbate economic downturns.

What is the best way to measure liquidity risk?

Measuring liquidity risk involves assessing the cash flow gap, liquidity coverage ratio, and market depth for assets. Stress testing under various scenarios is also a critical tool for understanding potential liquidity challenges.

Also read - What is market risk definition?

Summary

Managing liquidity risk is crucial for the stability of financial systems, companies, and individual financial health in India. Effective management involves understanding the nuances of liquidity needs, maintaining sufficient liquid assets, and planning for adverse conditions. As the Indian economy continues to evolve, the management of liquidity risk remains a cornerstone of financial planning and stability.

The Bajaj Finserv Platform offers over 1000 mutual funds schemes, providing a lot of choices for both companies and individual investors to manage their money wisely. Whether you're looking for loans or shares, Bajaj Finserv Mutual Fund Platform has something for everyone to match their financial needs. It makes borrowing cheaper and helps your money grow, playing a big part in smart financial planning, especially when dealing with the challenge of having enough cash on hand (liquidity risk) which also gives you the options for SIP calculator and lumpsum calculator.

Calculate your expected investment returns with the help of our investment calculators

Investment Calculator

SIP Calculator

Lumpsum Calculator

Step Up SIP Calculator

Mutual Fund Calculator

Brokerage Calculator

FD calculator

Frequently asked questions

What is liquidity or credit risk?
Liquidity risk and credit risk are distinct concepts. Liquidity risk involves the inability to quickly convert assets into cash without significant loss in value, affecting an entity's capacity to meet its immediate obligations. Credit risk, on the other hand, pertains to the potential that a borrower will default on a debt obligation.
What is capital and liquidity risk?
Capital risk and liquidity risk involve different aspects of financial management. Capital risk refers to the potential loss or devaluation of an investment, impacting an entity's capital base. Liquidity risk is about the challenge of converting assets into cash quickly without a substantial loss, affecting the entity's ability to cover immediate and short-term liabilities.
What is the definition of liquidity?
Liquidity in finance refers to the ease with which an asset can be converted into cash without affecting its market price. High liquidity indicates that the asset can be sold quickly, and there is minimal difference between the listing price and selling price, facilitating smoother transactions and financial operations.
What is the meaning of liquidity risk?
Liquidity risk signifies the danger that an entity may not be able to meet its short-term financial obligations due to the inability to convert assets into cash quickly or at a reasonable price. It highlights the potential for financial distress or losses stemming from the lack of market liquidity or sufficient cash flow.
What is an example of a liquidity risk situation?

A typical example of liquidity risk occurs when a company faces sudden demands for cash but lacks sufficient liquid assets or access to credit to meet these obligations promptly. This can lead to difficulties in paying suppliers, meeting payroll, or servicing debt.

What are the causes of liquidity risk?

Liquidity risk can arise from various factors such as mismatches between assets and liabilities, sudden withdrawals of funds by investors, adverse market conditions affecting asset liquidity, or operational issues impacting cash flow.

How do you measure liquidity risk?

Liquidity risk is measured using indicators like the current ratio, quick ratio, cash conversion cycle, and the bid-ask spread. These metrics assess a company's ability to meet short-term obligations without causing significant losses in asset value.

What provides liquidity risks?

Liquidity risks are primarily provided by the imbalance between a company's liquid assets and its short-term liabilities, making it challenging to convert assets into cash quickly when needed.

How to avoid liquidity risk?

Mitigating liquidity risk involves maintaining adequate cash reserves, managing cash flow efficiently, diversifying funding sources, maintaining good relationships with lenders, and conducting stress tests to anticipate and prepare for liquidity challenges.

Who is most affected by liquidity risk?

Businesses, financial institutions, and investors are most affected by liquidity risk. Companies with extensive short-term debt obligations and insufficient cash reserves are particularly vulnerable.

How do we manage liquidity risk?

Managing liquidity risk involves proactive cash flow forecasting, establishing contingency plans, maintaining a diversified portfolio of liquid assets, monitoring market conditions, and maintaining access to emergency funding sources like credit lines.

Show More Show Less

Related videos

Bajaj Finserv app for all your financial needs and goals

Trusted by 50 million+ customers in India, Bajaj Finserv App is a one-stop solution for all your financial needs and goals.

You can use the Bajaj Finserv App to:

  • Apply for loans online, such as Instant Personal Loan, Home Loan, Business Loan, Gold Loan, and more.
  • Invest in fixed deposits and mutual funds on the app.
  • Choose from multiple insurance for your health, motor and even pocket insurance, from various insurance providers.
  • Pay and manage your bills and recharges using the BBPS platform. Use Bajaj Pay and Bajaj Wallet for quick and simple money transfers and transactions.
  • Apply for Insta EMI Card and get a pre-qualified limit on the app. Explore over 1 million products on the app that can be purchased from a partner store on Easy EMIs.
  • Shop from over 100+ brand partners that offer a diverse range of products and services.
  • Use specialised tools like EMI calculators, SIP Calculators
  • Check your credit score, download loan statements and even get quick customer support—all on the app.

Download the Bajaj Finserv App today and experience the convenience of managing your finances on one app.

Do more with the Bajaj Finserv App!

UPI, Wallet, Loans, Investments, Cards, Shopping and more

GET THE APP

Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.

Disclaimer:

Bajaj Finance Limited ("BFL") is registered with the Association of Mutual Funds in India ("AMFI") as a distributor of third party Mutual Funds (shortly referred as 'Mutual Funds) with ARN No. 90319

BFL does NOT:

(i) provide investment advisory services in any manner or form:

(ii) carry customized/personalized suitability assessment:

(iii) carry independent research or analysis, including on any Mutual Fund schemes or other investments; and provide any guarantee of return on investment.

In addition to displaying the Mutual fund products of Asset Management Companies, some general information is sourced from third parties, is also displayed on As-is basis, which should NOT be construed as any solicitation or attempt to effect transactions in securities or the rendering any investment advice. Mutual Funds are subject to market risks, including loss of principal amount and Investor should read all Scheme/Offer related documents carefully. The NAV of units issued under the Schemes of mutual funds can go up or down depending on the factors and forces affecting capital markets and may also be affected by changes in the general level of interest rates. The NAV of the units issued under the scheme may be affected, inter-alia by changes in the interest rates, trading volumes, settlement periods, transfer procedures and performance of individual securities forming part of the Mutual Fund. The NAV will inter-alia be exposed to Price/Interest Rate Risk and Credit Risk. Past performance of any scheme of the Mutual fund do not indicate the future performance of the Schemes of the Mutual Fund. BFL shall not be responsible or liable for any loss or shortfall incurred by the investors. There may be other/better alternatives to the investment avenues displayed by BFL. Hence, the final investment decision shall at all times exclusively remain with the investor alone and BFL shall not be liable or responsible for any consequences thereof.

Investment by a person residing outside the territorial jurisdiction of India is not acceptable nor permitted.

Disclaimer on Risk-O-Meter:

Investors are advised before investing to evaluate a scheme not only on the basis of the Product labeling (including the Riskometer) but also on other quantitative and qualitative factors such as performance, portfolio, fund managers, asset manager, etc, and shall also consult their Professional advisors, if they are unsure about the suitability of the scheme before investing.


Disclosure: Bajaj Finance Limited (BFL) is a distributor of Mutual Funds with ARN - 90319 and distributes mutual funds of Bajaj Finserv Asset Management Limited (BFSAMC). BFL receives commission towards distribution of mutual fund products. BFSAMC is a group company of BFL, carrying business on arm’s length basis without any conflict of interest and in accordance with the prevailing law / regulation.