Liquidity refers to the ability of a company to make cash payments as they become due.

Financial institutions that are solvent can—and sometimes do—fail because of liquidity problems.
It is important to distinguish solvency from liquidity. Solvency refers to a company having more
assets than liabilities, so that the value of its equity is positive. Consider a bank whose assets are
mostly illiquid mortgages. Suppose the assets are financed 90% with deposits and 10% with equity.
The bank is comfortably solvent. But it could fail if there is a run on deposits with 25% of
depositors suddenly deciding to withdraw their funds.
It is clearly important for financial institutions to manage liquidity carefully.
Liquidity needs are uncertain. A financial institution should assess a worst-case liquidity scenario
and make sure that it can survive that scenario by either converting assets into cash or raising cash
in some other way.
Sources of Liquidity
The main sources of liquidity for a financial institution are:
1. Holdings of cash and treasury securities
2. The ability to liquidate trading book positions
3. The ability to borrow money at short notice
4. The ability to offer favorable terms to attract retail and wholesale deposits at short notice
5. The ability to securitize assets (such as loans) at short notice
6. Borrowings from the central bank

Cash and Treasury Securities

Cash and Treasury securities are excellent sources of liquidity. Cash is of course always
available to meet liquidity needs and treasury securities issued by countries such as the United
States and the United Kingdom can generally be converted into cash at short notice without any
problem. However, cash and treasury securities are relatively expensive sources of liquidity.
There is a trade-off between the liquidity of an asset and the return it provides. In order to be
profitable, a financial institution needs to invest in assets such as loans to corporations that provide
a higher rate of return than treasury instruments. There is therefore a limit to the cash and treasury
securities that can reasonably be held.
Liquidating Trading Book Positions
Liquidity funding risk is related to liquidity trading risk, because one way a financial
institution can meet its funding requirements is by liquidating part of its trading book. It is therefore
important for a financial institution to quantify the liquidity of its trading book so that it knows
how easy it would be to use the book to raise cash. The financial institution wants to make sure
that it will be able to survive stressed market conditions where there is a general shortage of
liquidity. The financial institution’s analysis should therefore be based on stressed market
conditions, not normal market conditions.
Ability to Borrow
When markets are unstressed, a creditworthy bank usually has no problem in borrowing
money, but in stressed market conditions there is a heightened aversion to risk. This leads to higher
interest rates, shorter maturities for loans, and in some cases a refusal to provide funds at all.
Financial institutions should monitor the assets that can be pledged as collateral for loans at short
notice. A financial institution can (at a cost) mitigate its funding risks somewhat by arranging lines
of credit. For example, Countrywide, an originator of mortgages in the United States, had a
syndicated loan facility of $11.5 billion, which it was able to use during the credit crisis of 2007.
(This helped keep the company afloat, but it still experienced significant problems and was taken
over by Bank of America in January 2008.)
Wholesale and Retail Deposits
Wholesale deposits are a more volatile source of funding than retail deposits and can
disappear quickly in stressed market conditions. Even retail deposits are not as stable as they used
to be because it is very easy to compare interest rates offered by different financial institutions and
make transfers via the Internet. Unfortunately, liquidity problems tend to be market-wide rather
than something that affects one or two financial institutions. When one financial institution wants
to increase its retail or wholesale deposit base for liquidity reasons by offering more attractive rates
of interest, others usually want to do the same thing and the increased funding is likely to be
difficult to achieve.
Central Bank Borrowing
Central banks (e.g., the Federal Reserve Board in the United States, the Bank of England
in the UK, or the European Central Bank) are often referred to as “lenders of last resort.” When
commercial banks are experiencing financial difficulties, central banks are prepared to lend money
to maintain the health of the financial system. Collateral has to be posted by the borrowers and the
central bank typically applies a haircut (i.e., it lends less than 100% of the value of the collateral)
and may charge a relatively high rate of interest.
Liquidity risk refers to the potential difficulty an entity may face in meeting its short-term
financial obligations due to an inability to convert assets into cash without incurring a substantial
loss. This risk is inherent in both financial institutions and corporations, significantly impacting
their operational and financial stability.
There are two types of liquidity risk: liquidity trading risk and liquidity funding risk.
Liquidity trading risk is concerned with the ease with which positions in the trading book
can be unwound. Unwinding meant selling illiquid securities and buying liquid securities,
reinforcing the flight to quality and making it more severe than previous flights to quality.
The liquidity trading risk of an asset depends on the nature of the asset, how much of the asset is
to be traded, how quickly it is to be traded, and the economic environment. The credit crisis of
2007 emphasizes the importance of transparency. Assets that are not well defined or well
understood are unlikely to trade in a liquid market for long.
The liquidity of an asset at a particular time can be measured as the dollar bid– offer spread
or as the proportional bid–offer spread. The latter is the difference between the bid and offer price
divided by the average of the bid and offer price. The cost of unwinding a position in the asset is
half of the bid–offer spread. Financial institutions should monitor the cost of unwinding the whole
trading book in both normal market conditions and stressed market conditions.
A trader, when faced with the problem of unwinding a large position in an asset, has a
trade-off between the bid–offer spread and market risk. Unwinding quickly leads to high bid–offer
spreads, but low market risk. Unwinding slowly leads to lower bid–offer spreads, but more market
risk. The optimal trading strategy depends on (a) the dollar bid–offer spread as a function of the
quantity traded in a day and (b) the probability distribution for daily changes in the asset price. For
any particular unwind strategy, the trader can choose a confidence level and calculate the unwind
cost that will not be exceeded with the confidence level. The unwind strategy that minimizes this
cost can then be determined.
We now move on to consider liquidity funding risk. This pertains to the inability to obtain
sufficient funding to meet financial obligations. Financial institutions that are solvent (i.e., have
positive equity) can, and sometimes do, fail because of liquidity problems.
Liquidity funding problems at a financial institution can be caused by:
1. Liquidity stresses in the economy (e.g., a flight to quality such as that seen during the 2007
to 2009 crisis). Investors are then reluctant to provide funding in situations where there is
any credit risk at all.
2. Overly aggressive funding decisions. There is a tendency for all financial institutions to use
short-term instruments to fund long-term needs, creating a liquidity mismatch. Financial
institutions need to ask themselves: “How much of a mismatch is too much?”
3. A poor financial performance, leading to a lack of confidence. This can result in a loss of
deposits and difficulties in rolling over funding.

Liquidity funding risk management is concerned with being able to meet cash needs as they
arise. It is important for a financial institution to forecast its cash needs in both normal market
conditions and stressed market conditions to ensure that they can be met with almost total certainty.
Cash needs depend on depositor withdrawals, drawdowns on lines of credit, guarantees that have
been made, defaults by counterparties, and so on.
Sources of cash are instruments that can be readily converted into cash, borrowings in the
wholesale market, asset securitizations, new depositors, cash itself, and (as a last resort)
borrowings from a central bank. In June 2008, bank regulators issued a list of 17 principles
describing how banks should manage their liquidity and indicated that they would be monitoring
the liquidity management procedures of banks more carefully in the future.
 The most serious liquidity risks arise from what are sometimes termed liquidity black
holes. These occur when all traders want to be on the same side of the market at the same time.
This may be because they have similar positions and manage risks in similar ways. It may also be
because they become irrationally exuberant, overexposing themselves to particular risks. What is
needed is more diversity in the trading strategies followed by market participants. Traders who
have long-term objectives should avoid allowing themselves to be influenced by the short-term
overreaction of markets.
The key to managing liquidity risk is predicting cash needs and ensuring that they can be
met in adverse scenarios. Some cash needs are predictable. For example, if a bank has issued a
bond, it knows when coupons will have to be paid. Others, such as those associated with
withdrawals of deposits by retail customers and drawdowns by corporations on lines of credit that
the bank has granted, are less predictable. As the financial instruments entered into by financial
institutions have become more complex, cash needs have become more difficult to predict.
Effective management of liquidity risk includes maintaining a portfolio of liquid assets,
rigorous cash flow forecasting, and diversifying funding sources.
Banks are guided by robust regulatory frameworks like Basel III, which sets stringent
liquidity standards to ensure financial stability and protect depositor interests, reflecting a global
emphasis on robust liquidity risk management.
Unmanaged or poorly managed liquidity risk can lead to operational disruptions, financial
losses, and reputational damage. In extreme cases, it can drive an entity towards insolvency or
bankruptcy.

Source/Reference Link:

1) https://www.investopedia.com/terms/l/liquidityrisk.asp

2) https://dl.rasabourse.com/Books/Finance%20and%20Financial%20Markets/%5BHull%5DRisk%20Manag
ement%20and%20Financial%20Institutions%28rasabourse.com%29.pdf