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What Is: Liquidity Risk?

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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.

This was a particularly acute problem for major financial institutions, who had borrowed heavily to issue hundreds of billions in asset-backed securities (debt securities based primarily on mortagages) counting on continued growth in the housing sector. But default rates amongst sub-prime increased with their mortgage APR’s , home building slowed, and the pool of eligible borrowers decreased, prompting sharp depreciations in value of real-estate portfolios on Wall Street. Because the value dropped significantly over a short period, ABS’s were harder for banks to sell without incurring steep losses themselves. That inability to find a buyer who would pay the price desired by the seller is the essence of liquidity risk, because the ABS’s couldn’t move at the prices banks needed to offset potential losses. 

How Do Financial Institutions Account For Liquidity Risk? 

Because liquidity risk is based on the marketability of a given asset, it is difficult to actually pinpoint an exact value for how much of a risk any one asset actually poses. However, there are a variety of metrics used in order to provide financial institutions with a better idea of what kinds of risks different assets pose. 

Measuring Liquidity Gap:

  • Generally, liquidity gap is the difference between a given institution’s assets and liabilities as a result of these groups of products not sharing like qualities. This ratio can either be positive or negative, depending on the values in each category. This measure is a static estimate of liquidity risk; it does little to forecast changes in liquidty as market conditions change. 

Accounting for Bid-Ask Spreads:

  • A bid-ask spread is a calculation that compares both the “ideal” purchase price and the sale price of a given asset at a specific point in time. Think of the bid as the highest price a buyer or group of buyers is willing to pay for a particular security and the ask as the lowest price a seller or group of sellers is willing to accept for the same security. The spread is the difference between these two quantities and is good for determining the liquidity risk of a given asset. Remember, liquidity risk is all about the seller being able to get the price he/she wants without losing much themselves or effecting a large change in the value of what they’re selling. So if the variance between what a seller wants to sell for thing X and what the buyer wants to pay for thing X is high, the liquidity risk presented the seller by X is higher because they can’t get the price they’re looking for,

Observing Market Depth: 

  • Market Depth attempts to provide an idea of how many buyers and sellers there are in a given market for a given security. Financial institutions calculate this by looking at the number of open buy and sell orders on a particular security which help to gauge how many people there are looking to purchase that security. A market is said to be deeper whenever the number of buy and sell orders are high as the price for the security in question changes throughout the trading day. High market depth usually implies lower liquidity risk because there are more people actually trading that asset and thus finding buyers is arguably easier. 

Other Techniques of Managing Liquidity Risk:

  • A lot of forecasting goes into calculating liquidity risks from changes in market values and perceptions of different asset classes, thus enabling financial institutions to game out different economic scenarios to test their different asset holdings. 
  • Having various liquidity providers is another common practice. To do this, financial institutions try to ensure that they have multiple sources to go to for credit, especially in the event that the liquidity risk from one or more of their asset types increases suddenly and they need capital in a pinch. In the United States, the Federal Reserve System acts in this capacity as a lender of last resort for America’s banks. 

Anything Else We Sould Know?

Its good to keep in mind that while asset values and pricing are tied to liquidity risk, the two are not one and the same. Liquidity risk can be posed by a single instrument or a single institution, so long as there are problems between the selling and buying prices of a given security. Managing this risk is essential for maintaining a stable financial system, and while the institutions themselves are the primary vehicles for this management, the government must implement fiscal policy that enforces oversight and prompts continual monitoring of liquidity risk from within the banking system itself. 

 

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About Alexander J Smith III

  • Igor

    Experienced traders say that “the market discounts everything”. Even the best asset gets some kind of discount (often based on liquidity) and the most worthless asset has some kind of value (even if vanishingly close to zero).

    And, of course, there are trading costs: brokers fees, exchange costs, transportation, etc.

    What upsets the discounting system is when government or private banks interfere to control events either with money or fiat law. That kind of interference, by either government or banking monoliths, is initiated by interested private parties who are invested in various positions. Contrary to the naive notions of ersatz-rightists from the hoi polloi, most market interference is initiated by powerful people with heavy investments, NOT by meddling leftist governments.