Liquidity risk and the management of liquidity risk are discussed in this post.

WHAT IS LIQUIDITY RISKS?

Liquidity is the ability of a firm, company, or individual to pay its debts without suffering catastrophic losses. Investors, managers, and creditors use liquidity measurement ratios when deciding the level of risk within an organisation. The ability of a financial institution to meet the demand for deposit withdrawals and other cash outflows is a good indicator of the firm’s viability. A firm’s liquidity management process should ensure that daily funding needs are met. 

Banks and other financial institutions should have a sound liquidity risk management framework for identifying, measuring, monitoring and controlling their liquidity risk. Liquidity risk may be either funding liquidity risk or asset liquidity risk. A sound liquidity risk framework should improve the resilience of a firm’s liquidity shocks and address fragilities identified during a liquidity shock crisis. The liquidity risk management framework should address expected and unexpected deviations from normal operations. The liquidity risk framework should be enhanced through suitable monitoring tools to identify and manage emerging liquidity risks.

The integration of liquidity risk into a robust risk management system is essential to ensure the viability of a firm. Some risks make sound liquidity risk management a considerable challenge for securities firms. Generally, banks and securities firms are susceptible to liquidity risks through their operations and activity. Banks enjoy a relatively stable core funding source through unsecured customer deposits, but securities firms are not deposit-taking institutions.

Securities firms would depend on their capital and ability to raise funds from external sources. This often makes securities firms relatively more exposed to funds providers’ price and credit risk sensitivities. In times of market stress or for reasons inherent in the firm (such as a rating downgrade), liquidity may not be accessible on a timely or cost-effective basis or in amounts sufficient to meet the firm’s needs, thereby endangering the firm’s capital and its existence.

SOURCES OF LIQUIDITY

For a company, its sources of liquidity are all the resources that can be used to generate cash. There are generally two primary sources of liquidity for a company: primary and secondary.

FACTORS INFLUENCING A FIRM’S LIQUIDITY RISK

Funding liquidity risk can be increased through the following elements:

1. Seasonal fluctuations in revenue generation,
2. Business disruptions,
3. Unplanned capital expenditures,
4. Increased operational costs,
5. Insufficient working capital management,
6. Poor matching of asset duration to debt duration,
7. Limited financing facilities, and
8. Poor cash flow management.

SOURCES OF LIQUIDITY FUNDING

There are two main ways of funding liquidity: assets and liabilities. 

LIQUIDITY RISK MANAGEMENT PROCESS

Essentially, businesses should have sound liquidity risk management. Liquidity risk management is a process of identifying, measuring, monitoring, and controlling liquidity risk to avoid liquidity problems and enhance a firm’s ability to meet its funding needs. 

CORE ELEMENTS OF LIQUIDITY RISK MANAGEMENT

Core elements of sound liquidity risk management include:

1. Effective corporate governance,
2. Appropriate policies, procedures, strategies, and limits,
3. Liquidity risk measurement, monitoring, and reporting,
4. Existing and potential funding sources,
5. Adequate levels of highly liquid marketable securities,
6. Comprehensive contingency funding plan, and
7. Internal controls.

See the full video on Liquidity Risk and Liquidity Risk Management: https://youtu.be/RzDx9JLeqCw