Importance Of Liquidity Risk Management

Introduction

In simple words, Liquidity risk is the risk, arising from the lack of marketability of a given security or asset that cannot be bought or sold quickly enough to prevent or minimize a loss. Although liquidity risk is largely associated with micro-cap and small-cap stocks or securities, it can sometimes affect even the biggest stocks during times of crisis. The aftermath of the 9/11 attacks and the 2007-2008 global credit crisis, when liquidity risk rose to abnormally high levels, are two relatively recent examples of how worse it can get. And the problem associated with rising liquidity risk is that, since panicky investors try to sell their holdings at any price, it causes large price declines, which further contributes to market

Financial market developments in the past decade have increased the complexity of liquidity risk and its management.

The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole. Banks deal with public deposits and hence the confidence of the public is very important for them to continue their operations. Banks’ major profit comes from lending operation. In the changing scenario, when the entire deposit portfolio has become payable on demand, it is very important for the banks to maintain sufficient liquidity. Thus measurement and management of liquidity risks become more relevant when it comes to banks. Effective liquidity risk management helps ensure a bank's ability to meet various obligations related to cash flow, which have a low level of certainty as they are influenced by external events and the behavior of other

In its purest form, it refers to storing liquidity in assets, primarily in cash and various marketable securities. When liquidity is needed, selected assets are converted in to liquid cash. This strategy is mainly adopted by smaller financial institutions as the risk associated with such an approach is minimum for liquidity management. There is, however an aspect of opportunity cost attached to it, because selling assets means loss of future earnings had those assets, not been sold. Moreover there is transaction cost and the risk of declining prices attached to it. Selling assets weaken the financial statements and since the interest attached to liquid assets are usually low, making investments in them generally means foregoing higher returns. In case the management is following this method, it must take care that assets with the least profit potential are sold first in order to minimize the opportunity