Liquidity risk refers to the risks arising either out of lack of liquidity of the holding shares or assets at the time of selling or out of lower liquidity holding of the banks as cash or cash equivalents. The first one is referred to as market liquidity and the second one is referred to funding liquidity.
Market Liquidity Risk
Market liquidity risk arises when the holding assets or shares don’t have adequate liquidity due to absence of buyers. In that case banks may need to sell the shares at much lower price than the original one, leading to loss. Suppose a bank holds share of XYZ Company but these shares are not traded in the stock market anymore due to absence of buyers. If the bank wants to sell the shares in the stock market, then it has to sell them at much lower price in order to complete the transaction. This can lead to significant amount of loss or reduce the actual profit from the investment.
The same thing has happened to the mortgage lenders during the subprime crisis when the price of the mortgaged houses fell significantly due to absence of new buyers and banks had no other options left except selling them in deep loss.
This can be possible for market traded corporate bonds as well. That’s the main reason banks should check the market liquidity of a share or bond before investing in them.
Funding Liquidity Risk
Funding liquidity risk arises if the banks do not have sufficient liquidity to meet its liabilities when the depositors withdraw their money or to provide new loans to the borrowers. This situation can arise due to liquidity tightening by the central banks or mismanagement of the existing liquidity. In both cases, banks are not able to generate required liquidity to meet its obligations and continue business operation.
In most of the cases, funding liquidity crisis is driven by the market liquidity crisis. If there is significant drop in market liquidity, banks have to sell their holdings at loss and they fail to generate the minimum liquidity for funding. During subprime crisis in 2008, first the price of the houses dropped which prompted the banks to sell their mortgaged houses at loss. That has led to severe liquidity crisis throughout the worldwide financial market. Bankruptcy declaration of some big banks has worsened the condition far beyond our imagination.