Liquidity Risk
Liquidity risk is the risk that a bank cannot meet its short-term financial obligations without incurring significant losses.
Meaning in Practice
In practice, liquidity risk arises when a bank faces sudden deposit withdrawals or funding disruptions. Banks manage this risk by holding high-quality liquid assets and maintaining diversified funding sources. Regulatory frameworks require compliance with liquidity ratios such as the Liquidity Coverage Ratio.
Why It Matters
Insufficient liquidity can quickly undermine confidence in a financial institution. Even solvent banks can fail if they cannot meet immediate payment obligations. Strong liquidity management supports resilience during market stress.
Market Impact
Heightened liquidity risk can increase interbank borrowing costs and reduce credit availability. Market participants may shift toward safer assets during liquidity stress. Severe liquidity shortages can trigger systemic crises.
Example
If large numbers of depositors withdraw funds simultaneously and a bank cannot raise cash quickly, it may be forced to sell assets at a loss to cover the outflows.