Liquidity risk is the exposure presented by an investment product that can't be bought or sold fast enough to prevent or offset losses incurred by the holder of that product.
What Types Of Liquidity Risk Are There?
There are two different types of liquidity risk: market and funding.
- Market liquidity risk refers to assets that can't be sold because of a general lack of liquidity in the market.
- Funding liquidity refers to balance sheet liabilities that either: can't be met when due, can only be satisfied at a price that is not economically beneficial or that present a systemic risk.
What Causes Liquidity Risk?
Liquidity risk can be caused by a wide variety of economic conditions, but in general, it occurs when one party (an investor or a bank) can't sell a particular asset on the open market because there's no other party able or willing to trade for it. It's easiest to think of liquidity risk as a lack of mobility for a given investment product, instead of a lack of value. For example, if the value of a stock falls to zero, the markets believe that stock to be worthless and as such it will be harder to sell if you are the bank or investor holding the stock. The lack of value increased the liquidity risk, because it is more difficult to locate someone willing to buy stock that no longer has value.
Another way to conceptualize liquidity risk, is to look back to the height of the sub-prime mortgage crisis. Financial institutions had been trading and exchanging trillions of dollars worth of asset-backed securities and credit-derivatives amongst themselves. Years of cheap government supplied funds had enabled aggresive securitization of assets like mortgages and banks used their control over interest rates to increase their future projections on returns from these products. In 2007, the market for products like credit-default swaps and mortgage-backed securities had low liquidity risk, because there were plenty of people in financial markets looking to buy and trade those products. But once the bottom began to fall out from under the ABS market (due mostly to speculation concerns over the strength of the housing market) the liquidity risk increased for anyone holding them as markets retreated away from ABS's and other credit derivatives.