Many people started to talk about liquidity risk after the global financial crisis. Historically, financial models do not include this risk. Yet, the global financial crisis has proven that people should always consider this type of risk.
One important reason for that is because when a non-depository or shadow banking system (the ones who provide short-term financing) withdraw liquidity, there can be a crisis. The effect, however, is not direct, yet still, result in the increasing collateral haircuts.
The Detail Definition and the Types
Liquidity always refers to how an asset or security can easily be sold or bought in the market. Or, the easier definition from liquidity is how fast something gets turned into cash.
We have two types of liquidity risk.
Funding Liquidity Risk
The other name of this type is cash flow liquidity risk. It usually becomes the primary concern of chief treasures since it is closely related to the ability of the firm to fund its liabilities.
We can see a company liquidity risk from its current ratio (the current liabilities or current assets) or the quick ratio.
Market Liquidity Risk
People may also refer to market liquidity risk as asset liquidity. It represents the inability of a firm to exit the position, easily.
For instance, there is someone who owns real estate. Yet, the person can only sell that asset at a sale price due to the bad market situation. Indeed, the asset still has value, yet there are temporarily decreasing buyers.
Market liquidity has various functions. One, it can function as the market microstructure. Two, it also functions as the asset type. Simple assets are generally more liquid than the complex asset.
Three, it also functions as the substitution. Once a position can be replaced easily with other instruments, then there will be higher liquidity and low substitution cost.
The last is the time horizon. If there is a seller with his or her urgency, then that will exacerbate this risk. Yet, the risk can become less of a threat if the seller shows some patient.