Liquidity

Risk
Herrera, John Alvin D.R.
Pelenio, Kritoffer
 What is Liquidity Risk
 Liquidity risk is a firm’s possible inability to meet its short-term debt obligations, thereby
incurring exceptionally large losses. This usually occurs as a result of a firm’s inability
to convert its current assets into cash without incurring capital losses.
 This risk occurs when the ask-bid spreads are widening out to levels that investors
need to spend large amounts of amount to deal with them. In general, this risk arises
when a firm or an individual face immediate cash needs that cannot be met by selling
an asset at its market value due to lack of buyers or due to an inefficient market that
cannot match buyers with sellers.
 Example of Liquidity Risk
 Vince is an economist at BDO. Going over the Bank’s latest statistics, he notices that the percentage of portfolio
transactions to assets has increased sharply, implying that BDO is shifting towards higher market risk.
 He wonders  if this increase in the percentage of portfolio transactions is related to the Bank’s revenues. If it
can be related, then the Bank has a satisfactory return with respect to the risk accepted.
 Vince goes over the Bank’s liquid assets. The sources of liquidity needed for responding to anticipated and
unanticipated changes in the balance sheet are sufficient. 10% of the Bank’s assets can be immediately
liquidated, which is generally a satisfactory percentage. However, Vince wonders if 10% is a satisfactory
liquidity percentage given the dynamics of the US market.
 The answer is no. The main source of the Bank’s liquidity is the deposits. Financing sources like the
interbank market and the term deposits add volatility to the level of commitment, thus increasing the Bank’s
cost of money. If the Bank borrows in foreign currency, it introduces currency risk. Furthermore, the
growing uncertainty following the regulatory liquidity requirements has forced banks to maintain a defensive
attitude by putting a higher percentage of their balance sheets – more than 30% – in highly liquid assets.
 Example
 Vince writes a memo where he suggests the following liquidity improvement measures:
• Increasing the asset positions in readily marketable high-quality components
• Reducing the duration of assets
• Increasing the duration of liabilities
• Diversifying the money sources by duration, geographic area, and lender
• Studying the composition of deposits and extending the sources of fixed funding
• Increasing the loans that can easily be sold or securitized
 With these liquidity risk management measures, the Bank is expected to increase its
liquidity, thus avoiding exposure to liquidity risk in the short-term.
How to effectively manage
liquidity Risk
Liquidity Risk Management
In Banking
 Summary
 Liquidity risk is the chance that a company will not be able to service its short-term debt
obligations and will have to pay additional fines and penalties or lose business.