What is liquidity risk? Liquidity risk is the inability of banks and financial institutions to convert assets into cash and repay short-term debts.
What is liquidity risk?
Liquidity Risk is considered one of the three most important risks of commercial banks. This risk occurs when the bank does not have enough cash and its borrowing capacity is also limited, leading to difficulties in meeting customers' withdrawal needs and other cash requirements. In other words, Bank liquidity risk Occurs when a bank is unable to meet its short-term debt obligations.
What is liquidity risk management?
Liquidity risk management is defined through three main elements:
- Arises when a bank is unable to meet its short-term debt obligations.
- This is the management process to identify, control, prevent and minimize losses caused by liquidity risk.
- Liquidity risk management It is not only the responsibility of commercial banks but also the obligation of the State Bank of Vietnam.
Causes of liquidity risk
Objective reasons
- Interest rate fluctuations: Any change in interest rates affects the deposit and loan flows of banks as well as organizations and businesses. When interest rates change, the psychology of depositors will also change, leading to corresponding changes in behavior and cash flow.
- Monetary policy: The Central Bank (CB) needs to implement monetary policies to manage the money supply in the financial market. Monetary tools such as open market operations, required reserve ratio, discount and rediscount rates will affect the operations and solvency of commercial banks (CBs) and businesses.
- Investment and business activities: Activities smart investment and business is often cyclical. For example, at the end of the year, the demand for investment, payment, settlement and disbursement increases (due to businesses paying salaries, paying debts, etc.), increasing the demand for cash, putting pressure on the liquidity of banks and businesses.
- Market fluctuations: Factors such as economic crisis, high inflation and even inaccurate rumors can create great pressure on banks and businesses. These factors directly affect the production, business and investment activities of enterprises and the lending activities of banks.
Besides, corporate liquidity risk also comes from other factors such as stock prices (when customers pledge stocks to banks), commodity market risks (when prices fall, causing sellers to be unable to repay bank loans on time), changes in commodity policies, natural disasters, reputational risks, corporate moral risks and many other factors.
Subjective causes
The internal operations of businesses and banks can also lead to liquidity risk. For example, when banks borrow excessively or businesses use short-term funds for long-term investments, there will be an imbalance between the duration of capital and the source of capital. If the profits from investments are not enough to cover the costs including interest incurred, liquidity risk will occur.
What is the importance of liquidity risk?
For banks
Importance of What is liquidity risk? When banks become insolvent, they are forced to accept high fees to meet urgent payment needs. This makes borrowing conditions more difficult, leading to a decline in bank profits and assets. As liquidity risk increases, banks face operational disruptions that prevent customers from making transactions and abandoning the bank, leading to a decline in reputation and loss of customers.
Customers who deposit money in banks are also affected when they cannot withdraw money for various purposes. investment knowledge, production or business. They will doubt the bank's ability to support them financially and demand withdrawals, putting great pressure on the bank. The more customers withdraw their money, the more losses the bank suffers, leading to loss of trust and customer relationships.
For shareholders, when they do not receive dividends or debts are not fully paid, they will lose confidence in the company. Their investment goal is to make a profit and they will ask the company to pay the debt or transfer their investment capital elsewhere.
In severe cases, banks may face bankruptcy or mergers. At this time, the State Bank will act as a lender of last resort, helping commercial banks overcome difficulties and restore stability to the banking system.
For business
When a business is unable to pay its debts, creditors will continue to tighten their grip on the debt and partners will be hesitant to supply raw materials. Borrowing or raising capital also becomes difficult, and businesses have difficulty finding a reliable sponsor.
The first consequence is that production and business activities are stagnant due to lack of raw materials and the inability to pay salaries to employees. The goods produced are not enough to supply customers, causing serious damage to the business. If this situation continues, the business will face the risk of bankruptcy.
In terms of socio-economics, Bank liquidity risk causing banks and businesses to have difficulty in mobilizing capital, providing credit and supporting the economy. When there is a lack of capital, business activities stagnate, inflation increases, investment decreases and the economy weakens. This will affect people's lives.
For developed countries, which have a large influence on the global economy, liquidity risk can cause political collapse and have consequences for other countries.
Examples of trade liquidity risk
An important lesson for the global economy was the collapse of Lehman Brothers in 2008. It was one of the largest investment banks in the US, with 25,000 employees worldwide at the time. Although the collapse was not directly caused by corporate liquidity risk, but it created a serious liquidity crisis and had knock-on effects on the US and global economies, including Vietnam.
With a debt of over $600 billion, Lehman Brothers declared bankruptcy on September 15, 2008. During the crisis and bankruptcy, the bank lost all confidence from its customers, leading to a massive withdrawal of money. At that time, Lehman Brothers could not meet the large withdrawal demand, causing the bank to sink deeper into crisis and weaken.
From this event, we not only clearly see the serious consequences of liquidity risk but also realize the close relationship between credit risk and liquidity risk. When both of these problems occur at the same time, they can cause very serious impacts on the economy.
The above article by HVA has helped you understand more about What is liquidity risk? and signs of liquidity risk. In short, liquidity risk plays an extremely important role in managing bank operations. The existence and sustainability of a bank or financial institution depends largely on their ability to manage liquidity.
