Liquidity risk is the risk of loss resulting from the inability to meet payment obligations in full and on time when they become due.
Liquidityrisk is inherent to the Bank's business and results from the mismatch inmaturities between assets and liabilities. It may be related to funding – impossibilityto obtain new funding – and to markets – inability to sell or convert liquidassets into cash without significant losses.
TheCEB manages liquidity risk in a prudent manner, holding a liquidity reserve ofhighly rated liquid securities to cope with periods of extreme marketconditions during which new funding would become inaccessible. The fundingstrategy is an important element of liquidity risk management, with the CEBdiversifying its debt issuance programs, funding markets and investor base toavoid over-reliance on individual markets or funding sources.
TheCEB measures liquidity risk using internal metrics and regulatory indicatorscomplemented by qualitative analysis in line with Baseland EU regulations. It defines its risk appetite based on the SurvivalHorizon metric, which measures the period during which it can meet its paymentobligations arising from ongoing business operations under severe stress scenarios,and also by meeting the regulatory requirements for the Liquidity CoverageRatio and the Net Stable Funding Ratio.
FAQs
Management of liquidity risk is critical to ensure that cash needs are continuously met. For instance, maintaining a portfolio of high-quality liquid assets, employing rigorous cash flow forecasting, and ensuring diversified funding sources are common tactics employed to mitigate liquidity risk.
What is liquidity risk in simple words? ›
Liquidity risk is the risk of loss resulting from the inability to meet payment obligations in full and on time when they become due. Liquidity risk is inherent to the Bank's business and results from the mismatch in maturities between assets and liabilities.
What best describes liquidity risk? ›
A liquidity risk is defined by an entity's lack of cash that hinders it from repaying short-term debt, resulting in excessive capital losses.
How do you quantify liquidity risk? ›
How Do You Measure Liquidity Risk?
- The current ratio or working capital. This compares current assets, including inventory, and liabilities.
- The acid test, or quick ratio. This measures only current assets, such as cash equivalents, against liabilities.
- The cash ratio or net working capital.
The three main types are central bank liquidity, market liquidity and funding liquidity.
How do you solve a liquidity trap? ›
Overcoming a Liquidity Trap
The monetarist view suggests quantitative easing as a solution to the liquidity trap. Quantitative easing usually means that the central bank sets up a goal of high rates of increase in the monetary base or money supply and provides liquidity in the economy so as to achieve the goal.
What are the two 2 types of liquidity risk? ›
It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.
Why is liquidity risk bad? ›
Market liquidity risk
When market liquidity begins to falter, financial markets experience less reliable pricing, and can tend to overreact. This has a knock-on effect, leading to an increase in market volatility and higher funding costs.
How do banks solve liquidity problems? ›
First, banks can obtain liquidity through the money market. They can do so either by borrowing additional funds from other market participants, or by reducing their own lending activity. Since both actions raise liquidity, we focus on net lending to the financial sector (loans minus deposits).
What is an example of a liquidity problem? ›
A liquidity crisis occurs when a company can no longer finance its current liabilities from its available cash. For example, it is no longer able to pay its bills on time and therefore defaults on payments. In order to avoid insolvency, it must be able to obtain cash as quickly as possible in such a case.
Liquidity Risk Indicators: Low levels of cash reserves, high dependency on short-term funding, or a high ratio of loans to deposits can hint at liquidity risk. Such indicators help banks ensure they can meet their financial obligations as they come due.
What is liquidity risk in a business? ›
FOR A BUSINESS, LIQUIDITY RISK DESCRIBES A POTENTIAL INABILITY TO ADDRESS SHORT-TERM CASH OUTFLOW. FOR INVESTORS, ON THE OTHER HAND, IT DESCRIBES THE RISK OF NOT FINDING COUNTERPARTIES WILLING TO PAY THE APPLICABLE MARKET PRICES FOR THEIR TRANSACTIONS.
How do you analyze liquidity? ›
The three main liquidity ratios are the current, quick, and cash ratios. The current ratio is current assets divided by current liabilities. The quick ratio is current assets minus inventory divided by current liabilities. The cash ratio is cash plus marketable securities divided by current liabilities.
How do you identify liquidity? ›
Usually, liquidity is calculated by taking the volume of trades or the volume of pending trades currently on the market. Liquidity is considered “high” when there is a significant level of trading activity and when there is both high supply and demand for an asset, as it is easier to find a buyer or seller.
How can a business overcome a liquidity problem? ›
Ways in which a company can increase its liquidity ratios include paying off liabilities, using long-term financing, optimally managing receivables and payables, and cutting back on certain costs.
Which tool is used to manage liquidity risk? ›
Liquidity management tools—such as pricing arrangements, notice periods and suspension of redemption rights—can help alleviate the liquidity risk generated by investment funds.
