How do you quantify liquidity risk?
To measure the liquidity risk in banking, you can use the ratio of loans to deposits. A liquidity risk example in banks is a decline in deposits or rise in withdrawals (which are liabilities for the bank). As a result, the bank is unable to generate enough cash to meet these obligations.
How do we measure liquidity risk? Indicates a company's ability to meet upcoming debt payments with the most liquid part of its assets (cash on hand and short-term investments). It is the ratio between current assets (liquid resources of the company) and current liabilities (short-term debts).
Some different baseline liquidity metrics include Loan-to-Deposit ratios, 1-week & 1-month liquidity ratios, Cumulative liquidity models, Liquidity risk factors, Concentration and funding source reports, and Inter-entity lending reports.
Liquidity Risk Calculation Example
Starting with the current ratio, the formula consists of dividing the “Total Current Assets” by the “Total Current Liabilities”. From Year 1 to Year 4, the current ratio has expanded from 0.5x to 1.0x, which implies the company's liquidity position is improving over time.
Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding. Liquidity ratios determine a company's ability to cover short-term obligations and cash flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts.
The five monitoring tools (metrics) specified by BCBS are: a) Contractual maturity mismatch; b) Concentration of funding; c) Available unencumbered assets; d) LCR by significant currency; and e) Market-related monitoring tools.
- Current Ratio = Current Assets / Current Liabilities.
- Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities.
- Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.
- Net Working Capital = Current Assets – Current Liabilities.
Liquidity.
This KPI tracks how much money is available in your business. Liquidity is the difference between your current assets and your liabilities. Assets include the cash you have in the bank, the invoices you have already sent out, and your stock. Liabilities include accounts payable.
Current, quick, and cash ratios are most commonly used to measure liquidity.
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.
How do you measure liquidity in a portfolio?
Liquidity measures can be classified into four categories: (i) transaction cost measures that capture costs of trading financial assets and trading frictions in secondary markets; (ii) volume-based measures that distinguish liquid markets by the volume of transactions compared to the price variability, primarily to ...
Trading liquidity risk and funding liquidity risk are two main types of liquidity risks. A trading liquidity risk arises when investors are unable to sell an asset within a reasonable time frame at a fair price. A funding liquidity risk is a risk that an entity runs where it is unable to repay debt obligations.
Liquidity is a bank's ability to meet its cash and collateral obligations without sustaining unacceptable losses. Liquidity risk refers to how a bank's inability to meet its obligations (whether real or perceived) threatens its financial position or existence.
The two measures of liquidity are: Market Liquidity. Accounting Liquidity.
LIQUIDITY RISK MEASUREMENT
To identify potential funding gaps, banks typically monitor cash flows, assess the stability of funding sources, and project future funding needs.
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.
| Liquidity Ratios | Formula |
|---|---|
| Current Ratio | Current Assets / Current Liabilities |
| Quick Ratio | (Cash + Marketable securities + Accounts receivable) / Current liabilities |
| Cash Ratio | Cash and equivalent / Current liabilities |
| Net Working Capital Ratio | Current Assets – Current Liabilities |
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.
In monitoring liquidity, it is essential to understand the identification and taxonomy of cash flows that occur during the business activities of a financial institution and, importantly, the deterministic and stochastic cash flows. These cash flows help in building practical tools to monitor and manage liquidity risk.
The most precise test of liquidity is 'Absolute liquid ratio'.
What are the three types of liquidity risk?
The three main types are central bank liquidity, market liquidity and funding liquidity.
Stocks of small and mid-cap companies have high market liquidity risk, as stated above. This is because buyers are uncertain of their potential growth in the future and hence, are unwilling to purchase such securities in fear of incurring losses in the long term.
A liquidity risk example in banks is a decline in deposits or rise in withdrawals (which are liabilities for the bank). As a result, the bank is unable to generate enough cash to meet these obligations. This was dramatically illustrated by the global financial crisis of 2008-2009.
(i) The maturity ladder
A maturity ladder should be used to compare a bank's future cash inflows to its future cash outflows over a series of specified time periods. Cash inflows arise from maturing assets, saleable non-maturing assets and established credit lines that can be tapped.
Important to note is that a company is considered financially strong if it achieves a solvency ratio exceeding 20%. So, from our example above, it is clear that if SalesSmarts keeps up with the trend each year, it can repay all its debts within four years (100% / 24.6% = Approximately four years).
References
- https://www.boj.or.jp/en/announcements/press/koen_2001/ko0112a.htm/
- https://www.investopedia.com/articles/trading/11/understanding-liquidity-risk.asp
- https://academic.oup.com/cmlj/article/18/2/233/7067216
- https://fastercapital.com/content/What-is-Credit-Risk-Strategy.html
- https://www.equifax.com/personal/education/credit/score/articles/-/learn/what-is-a-good-credit-score/
- https://www.linkedin.com/pulse/4-best-financial-kpis-every-company-should-measuring-bernard-marr
- https://groww.in/p/liquidity-risk
- https://www.bankatfirst.com/business/resources/commercial/purpose-where-four-cs-credit-worthiness-converge.html
- https://www.federalreserve.gov/econres/feds/monetary-policy-in-deflation-the-liquidity-trap-in-history-and-practice.htm
- https://www.vedantu.com/commerce/credit-creation-by-commercial-bank
- https://www.tutorchase.com/answers/ib/economics/why-might-monetary-policy-be-ineffective-in-a-liquidity-trap
- https://www.eajournals.org/wp-content/uploads/Credit-Risk-Management-System-of-Commercial-Banks-An-Analysis-of-the-Process.pdf
- https://www.highradius.com/resources/Blog/strategies-involved-in-credit-risk-management/
- https://ginimachine.com/blog/5-the-best-credit-risk-management-tools-to-use-in-2023/
- https://byjus.com/question-answer/the-most-precise-test-of-liquidity-is/
- https://www.investopedia.com/ask/answers/040115/what-most-important-c-five-cs-credit.asp
- https://financeunlocked.com/videos/liquidity-risk-metrics
- https://corporatefinanceinstitute.com/resources/economics/liquidity-trap/
- https://www.3vfinance.com/infinance-le-blog/en/understanding-liquidity-risk-definition-causes-consequences
- https://www.investopedia.com/terms/l/liquidityratios.asp
- https://www.5paisa.com/stock-market-guide/generic/types-of-risk
- https://homework.study.com/explanation/1-if-the-economy-is-currently-in-a-liquidity-trap-an-increase-in-the-money-supply-would-shift-the-ms-curve-and-interest-rates-would-a-right-decrease-b-right-not-change-c-right-double.html
- https://www.wipfli.com/insights/articles/fi-ra-how-banks-can-manage-liquidity-risk
- https://en.wikipedia.org/wiki/Liquidity_trap
- https://www.spglobal.com/ratings/en/products-benefits/products/liquidity-assessments
- https://en.wikipedia.org/wiki/Credit_risk
- https://www.deccanherald.com/world/japan-s-debt-dilemma-and-its-balancing-act-2750760
- https://www.cbn.gov.ng/Out/2021/BSD/4.%20GUIDELINES%20ON%20LIQUIDITY%20MONITORING%20TOOLS%20(LMT).pdf
- https://www.financestrategists.com/wealth-management/investment-risk/credit-risk/
- https://www.ncontracts.com/nsight-blog/key-risk-indicators-for-banks/
- https://www.experian.com/blogs/ask-experian/which-investment-has-highest-risk/
- https://www.linkedin.com/pulse/what-different-types-credit-risk-alloy-apis-gdope
- https://www.bankofcanada.ca/wp-content/uploads/2010/12/wp10-38.pdf
- https://homework.study.com/explanation/1-when-the-money-market-is-in-equilibrium-in-the-liquidity-trap-investment-spending-falls-to-zero-an-increase-in-the-money-1-when-the-money-market-is-in-equilibrium-in-the-liquidity-trap-investmen.html
- https://www.bis.org/publ/bcbs10b.pdf
- https://research.stlouisfed.org/publications/economic-synopses/2022/08/23/liquidity-dries-up
- https://web.mit.edu/krugman/www/japtrap.html
- https://www.investopedia.com/terms/l/liquidity.asp
- https://corporatefinanceinstitute.com/resources/accounting/liquidity-ratio/
- https://www.wallstreetprep.com/knowledge/liquidity/
- https://testbook.com/question-answer/which-of-the-following-do-not-fall-under-the-categ--639ecaf071433f75f0b45239
- https://www.sas.com/el_gr/insights/risk-management/liquidity-risk.html
- https://www.ncoa.org/article/a-guide-to-types-of-investment-risk
- https://miuniversity.edu/news/how-do-i-calculate-the-liquidity-risk-of-a-company/
- https://defisolutions.com/defi-insight/credit-risk-management-strategies/
- https://smartasset.com/investing/solvency-vs-liquidity
- https://www.investopedia.com/terms/s/systematicrisk.asp
- https://gocardless.com/en-au/guides/posts/how-to-calculate-liquidity-ratios/
- https://onlinedegrees.scu.edu/media/blog/understanding-financial-risk-management
- https://www.occ.treas.gov/news-issuances/news-releases/1996/nr-occ-1996-2a.pdf
- https://corporatefinanceinstitute.com/resources/career-map/sell-side/risk-management/systematic-risk/
- https://www.nibmindia.org/static/working_paper/NIBM_WP05_ABMS.pdf
- https://corporatefinanceinstitute.com/resources/commercial-lending/solvency-ratio/
- https://trovata.io/blog/liquidity-management-strategies/
- https://www.360factors.com/blog/five-steps-of-risk-management-process/
- https://icfs.com/financial-knowledge-center/systematic-and-unsystematic-risk
- https://sphera.com/spark/everything-you-need-to-know-about-liquidity-risk/
- https://www.pulpstream.com/resources/blog/risk-management-process
- https://economictimes.indiatimes.com/definition/liquidity-trap
- https://www.cpaaustralia.com.au/-/media/project/cpa/corporate/documents/tools-and-resources/business-management/managing-liquidity-risk.pdf?rev=024f47972f4c488aa7799adf67e2d570
- https://corporatefinanceinstitute.com/resources/career-map/sell-side/risk-management/major-risks-for-banks/
- https://www.studysmarter.co.uk/explanations/macroeconomics/financial-sector/liquidity-trap/
- https://byjus.com/question-answer/what-is-liquidity-trap/
- https://byjus.com/question-answer/explain-paradox-of-thrift/
- https://web.pdx.edu/~ito/Liquidity_trap_RE_-HI2.pdf
- https://www.investopedia.com/ask/answers/062415/what-are-major-categories-financial-risk-company.asp
- https://8020consulting.com/principles-of-measuring-and-managing-liquidity-risk/
- https://groww.in/mutual-funds/debt-funds/credit-risk-funds
- https://www.linkedin.com/pulse/strategies-effective-credit-risk-management-banks-vatsal-tayal
- https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1008.pdf
- https://www.investopedia.com/ask/answers/040715/what-are-some-common-examples-unsystematic-risk.asp
- https://www.imf.org/external/pubs/ft/wp/2002/wp02232.pdf
- https://www.imf.org/-/media/Websites/IMF/imported-flagship-issues/external/pubs/ft/GFSR/2011/01/pdf/_chap2pdf.ashx
- https://www.levyinstitute.org/publications/japans-liquidity-trap
- https://web.ntpu.edu.tw/~hlchih/data/Financial%20Intitutions%20Management/Financial%20Institutions%20Management_Chap017.doc
- https://www.investopedia.com/terms/l/liquidityrisk.asp
- https://www.investopedia.com/financial-edge/0212/common-things-that-improve-and-lower-credit-scores.aspx
- https://www.cpb.nl/sites/default/files/omnidownload/CPB-Background-Document-August2016-Macro-econommics-of-balance-sheeets-problems-and-the-lquidity-trap.pdf
- https://hr.fullerton.edu/risk-management/information-and-document-requests/information-management/essential-techniques-of-risk-management.php
- https://byjus.com/commerce/liquidity-ratio/
- https://www.fdic.gov/resources/supervision-and-examinations/examination-policies-manual/section6-1.pdf
- https://smartasset.com/investing/systematic-risk
- https://gocardless.com/en-au/guides/posts/systemic-vs-systematic-risk/
- https://study.com/learn/lesson/liquidity-risk-funding-examples.html
- https://www.fe.training/free-resources/credit/credit-process/
- https://equitablegrowth.org/inflation-federal-reserve-policymaking-and-liquidity-traps/
- https://www.thebalancemoney.com/liquidity-position-analysis-with-ratios-393233
- https://www.factris.com/en/news/liquidity-problems-how-to-solve-them/
- https://www.piranirisk.com/blog/4-types-of-financial-risks
- https://www.investopedia.com/articles/investing-strategy/082816/methods-handling-risk-quick-guide.asp
- https://www.ey.com/en_ph/banking-capital-markets/managing-liquidity-risk-in-todays-environment
- https://fastercapital.com/content/What-is-Credit-Risk-Monitoring.html
- https://byjus.com/question-answer/what-are-two-measures-of-liquidity/
- https://navi.com/blog/liquidity-trap/
- https://www.unit21.ai/blog/risk-management-in-banking
- https://economics.mit.edu/sites/default/files/publications/Managing%20a%20liquidity%20trap%20%28Werning%29%202-7-12.pdf
- https://coebank.org/en/investor-relations/risk-management/liquidity-risk/
- https://en.wikipedia.org/wiki/Japanese_economic_miracle
- https://en.wikipedia.org/wiki/Liquidity_risk
- https://www.investopedia.com/articles/basics/07/liquidity.asp
- https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/templates-business-guides/glossary/liquidity
- https://quizlet.com/450407662/fina-465-ch-12-exam-3-flash-cards/
- https://scripbox.com/pf/liquidity-trap/
- https://www.upwork.com/resources/systematic-vs-unsystematic-risk
- https://www.leadsquared.com/industries/banking/credit-risk-management/
- https://www.sas.com/en_us/insights/risk-management/liquidity-risk.html
- https://analystprep.com/study-notes/frm/part-2/liquidity-and-treasury-risk-measurement-and-management/monitoring-liquidity/
- https://www.chaserhq.com/blog/how-to-reduce-your-business-credit-risk-5-strategies-to-implement-now
- https://www.linkedin.com/advice/0/how-do-you-benchmark-compare-your-market-risk
