Liquidity Risk

Liquidity risk involves assets not easily tradable without affecting value or a bank failing to meet obligations without significant losses.
Liquidity Risk
3 min
24-May-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.

Understanding Liquidity Risks with Types

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.

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.

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.

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.
Show More Show Less

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.
  • Explore and apply for co-branded credit cards online.
  • 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-approved limit on the app. Explore over 1 million products on the app that can be purchased from a partner store on No Cost 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

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.