This lesson examines liquidity risk, the risk that a financial institution cannot meet its short-term obligations .

5.1 Understanding Liquidity Risk
Liquidity risk is the risk that an institution will not be able to meet its financial obligations as they come due without adversely affecting its daily operations . It can be categorised into funding liquidity risk (difficulty in obtaining funds) and market liquidity risk (difficulty in selling assets without a price discount) . The 2008 financial crisis underscored the critical importance of managing liquidity .

5.2 Liquidity Measurement
Banks use a range of tools to monitor their liquidity position:

  • Gap Analysis: Comparing a bank’s rate-sensitive assets to its rate-sensitive liabilities over various time periods .

  • Liquidity Ratios: Financial metrics to assess liquidity.

  • Stress Testing: Modelling liquidity position under various adverse scenarios .

5.3 Liquidity Management
Key strategies for managing liquidity risk include:

  • Maintaining a Stable Funding Base: Relying on core customer deposits rather than volatile wholesale funding .

  • Holding High-Quality Liquid Assets (HQLA): Assets that can be easily sold to meet cash needs in a stress scenario.

  • Contingency Funding Planning: Developing plans to address a severe liquidity crisis .

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