Liquidity risk is a primary driver of systemic financial instability. Financial stability teams separate this hazard into two distinct, interacting operational categories: Funding Liquidity Risk and Market Liquidity Risk.
Deconstructing Liquidity Failures
  • Funding Liquidity Risk: The risk that an institution cannot meet its short-term cash obligations as they fall due, such as covering customer deposit withdrawals or settling interbank clearing balances.
  • Market Liquidity Risk: The risk that an asset cannot be liquidated quickly at a fair market price due to a lack of buyers or sudden market disruptions.

[Bank Faces Wholesale Funding Run] ---> Sells Bond Assets to Raise Quick Cash ---> Firesale Depresses Asset Valuations ---> Wipes Out Corporate Capital Reserves

During a financial crisis, these two risk categories can feed into each other: a bank facing funding liquidity stress may be forced to sell assets into a illiquid market, triggering a fire sale that depresses valuations and erodes capital reserves across the banking sector.
 
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