Liquidity risk - Financial definition
Concise definition of the term liquidity risk
Liquidity risk is the risk that an entity will be unable to meet its short-term financial obligations due to an inability to convert assets into cash without significant loss. It arises when there is a lack of market liquidity, making it difficult to buy or sell assets quickly at stable prices.
Comprehensive definition of the term liquidity risk
Liquidity risk can affect both individual institutions and the broader financial system, potentially leading to a credit crunch or financial crisis if not managed properly. For example, during the 2008 financial crisis, many banks and financial institutions faced severe liquidity risk, unable to sell their mortgage-backed securities and other assets without incurring substantial losses.
Market practices to mitigate liquidity risk include maintaining a diversified portfolio of assets, holding cash reserves, and employing stress testing to anticipate and prepare for potential liquidity shortfalls. Regulatory frameworks like the Basel III Accords have also introduced liquidity requirements to ensure financial institutions maintain adequate liquid assets to cover short-term obligations.