Funding Liquidity Risk

A risk that a company may not be able to meet its immediate and short-term obligations promptly

Author: Kavya Sharma
Kavya Sharma
Kavya Sharma
Reviewed By: Aditya Salunke
Aditya Salunke
Aditya Salunke
Last Updated:March 14, 2024

What is Funding Liquidity Risk?

Funding liquidity risk is the risk that a bank may not be able to repay its debt when it comes due. In other words, it is the risk that the bank cannot meet the needs of customers wishing to withdraw deposits.

On the other hand, market liquidity risk is the risk of not being able to sell an asset in time without a sharp price drop. Research has shown that funding liquidity problems can often lead to market liquidity risk and vice versa.

Banks engage in the maturity transformation business, which involves borrowing short (i.e., accepting client deposits) and lending long (i.e., providing mortgages). This puts the bank at risk of the liquidity of its financial resources.

Funding liquidity risk is an inherent part of the fractional reserve banking business model, and while it can be controlled, it cannot be eliminated.

Poor management of capital liquidity was one of the ultimate causes of banks failing or needing help from their governments during the 2007-2008 financial crisis. A key element of this is how liquidity risk has been assessed internally by the bank and how this has affected the pricing of its clients' products.

Key Takeaways

  • Funding liquidity risk is the risk that a bank may not be able to repay its debt when it comes due, and it can result from a mismatch between short-term deposits and long-term lending.
  • For companies, funding liquidity risk arises when short-term financial obligations exceed available cash flows, potentially leading to forced asset sales at unfavorable prices.
  • To mitigate liquidity risk, it's important to maintain a cash reserve for emergencies and strike a balance between liquid and illiquid assets, typically keeping around 60% of assets in highly liquid investments.
  • Liquidity plays a crucial role in balancing risk and returns in an investment portfolio, as it affects transaction speed, sales process ease, and contingency planning.

Understanding Funding Liquidity Risk

Liquidity is the ability to meet immediate and short-term obligations (less than one year). As such, a funding liquidity risk is a risk that a company may not be able to promptly meet its immediate and short-term obligations. 

This risk is a major concern for cyclical companies, where operating cash flows and debt obligation maturity may not match perfectly. For example, a company may experience a good season followed by a bad season.

During a recession, the company may be exposed to funding liquidity risk if its obligations maturing during that time exceed the operating cash flows generated. This can be illustrated below:

Illustration

PERIOD Q1 2020 Q2 2020 Q3 2020 Q4 2020
Operating Cash Flows  $3 Million $3 Million $0.5 Million $0.5 Million
Debt Obligations Due $2 Million $2 Million $2 Million $2 Million
Funding Liquidity Risk? Unlikely Unlikely Likely Likely

During Q3 2020 and Q4 2020, the company may not generate enough cash flow (assuming no cash reserves are maintained) to pay its liabilities. 

When a company is exposed to funding liquidity risk, it may have to liquidate its fixed assets (or other operating assets) below market value to meet its debt obligations. The sale of operating assets can seriously affect a company's ability to generate future revenue.

Factors that Increase Risk

Simply put, liquidity risk is the risk that a company does not have enough cash to meet its financial commitments on time. Without proper cash flow and liquidity risk management, a company will face a liquidity crisis and eventually become insolvent.

As companies begin measuring and managing liquidity risk, they need to be on the lookout for common sources of this risk. These sources include the ones mentioned below.

Lack of cash flow management

Cash flow management provides businesses with visibility into potential liquidity challenges and opportunities. 

In business, there is a saying; if cash is king, then the cash flow is the lifeblood of all businesses. Without proper cash flow management, a business increases the risk of unnecessary liquidity risk. 

In addition, a company without healthy and well-managed cash flow will face an uphill battle to stay profitable, secure favorable financial terms, attract potential inventors, etc., long-term feasibility and feasibility.

Inability to earn finance

A history of late repayment and/or non-compliance with loan agreement requirements can add to the difficulty of securing financing. 

Therefore, it is imperative that companies manage their capital structure well, match maturing liabilities with assets, maintain good relationships, and regularly communicate with lenders.

The inability to obtain financing or obtain it at competitive rates and on acceptable terms increases liquidity risk.

Unexpected economic disruption

At the beginning of 2020, the stock market was at an all-time high, and few expected the world to be hit hard by COVID-19. However, the negative economic impacts of this global pandemic were rapid and relentless. 

The closures have created unexpected economic disruptions, and many businesses have seen their sales drop to catastrophic levels and liquidity risk dramatically increase.

Unforeseen capital expenditures

Good management of fixed assets is extremely important, especially for a company operating in a capital-intensive industry such as energy, telecommunications, or transportation. A capital-intensive business typically has a high leverage ratio with a high fixed-cost to variable-cost ratio. 

For businesses like this, an unforeseen capital expenditure, such as a new purchase or major equipment repair, can exacerbate existing budget constraints. This further increases operating leverage and increases liquidity risk.

Profit crunch

A company in a profit crunch will see a drop in profit margins and sales. Therefore, it will need to start tapping into its cash reserves to combat negative margins and stay in business. 

The constant consumption of cash will eventually deplete the cash reserves, and the business will inevitably face a liquidity crunch.

Measuring Liquidity Risk

One of the key factors in measuring and managing liquidity risk is identifying the warning signs of a liquidity crisis. 

The loan-to-deposit ratio can be used to assess liquidity risk in banking. A decrease in deposits or an increase in withdrawals is two examples of liquidity risks in banks (which are liabilities for the bank). As a result, the bank cannot earn sufficient funds to pay its obligations.

Liquidity is important to business operations and there will be repercussions when it is mishandled, theoretically and practically. The amount of loss that can occur to these businesses varies. 

In some circumstances, it may be confined to losses resulting from higher funding costs or asset disposals at prices lower than carrying value; in others, it may be more significant, eventually leading to financial difficulties and collapse. 

Every entity subject to liquidity risk must thus try to avert damage by implementing a liquidity risk management plan. In addition to identifying these signs, a business must also assess the level of risk so that immediate and appropriate action can be taken to prevent a downward spiral.  

There are several ways to measure liquidity risk, which are: 

  • Financial ratio analysis: This involves using ratios obtained from financial statements to measure the financial well-being of a firm. Some common ratios used are current ratio, quick ratio, return on assets (ROA), and return on equity (ROE). 

  • Cash flow forecast: This involves assessing the past performance of a company, in order to predict future cash inflows and outflows. This is vital as it helps companies plan out their liquidity deficiencies. A forecast could cover from anywhere between a month to one year. 

  • Capital structure management: This measure primarily consists of equity and debt management (aka capital structure). It also involves finding a balance between short and long-term debt and diversifying sources of funding

Strategic Liquidity Planning

When planning your investments, it's imperative to factor in the liquidity of your plan to ensure that you've met your long-term and short-term needs. This will ensure that you won't touch your long-term investments. 

Some of the strategic liquidity planning involved:

1. Reserve cash reserve

No matter how much you invest in illiquid assets, you must keep a small portion of your money aside for immediate access. This keeps your money value the same instead of changing it due to a conversion. 

Your money should only be used for emergencies and should be replenished immediately. There is often a debate about the appropriate amount for such terms, but this is a personal parameter that varies between individuals depending on their needs. 

2. The balance between liquid assets and illiquid assets

You should have at least 60% of your assets invested in highly liquid assets such as stocks, bonds, mutual funds, and other alternative investment funds. 

These are the funds that you can withdraw every month. In the case of a listed investment option, you will need to ensure that you invest for the long term to avoid any impact on the price. Another important point to note is for private investments, where a certain part of the investment is in easy return options. 

The Role of Liquidity in Investment 

Liquidity plays an important role in balancing your portfolio with the balance between risk and return. For example, if you invest in emergency funds, you will have high liquidity but low returns and risks. 

Real estate investment comes with low risk and higher returns, but liquidity is compromised. 

In the long run, buying stocks and mutual funds generates higher returns with cash, but it also comes with higher risks. But despite these scenarios, it is an important component of portfolio investing. 

The importance of liquidity in investment arises from the following reasons:

1. Liquidity helps speed up transactions 

A liquid fund greatly reduces the time you sell your property until you find a buyer. Stocks are a good example of a liquid asset that can be traded on any business day. 

2. Liquidity facilitates the sales process 

Finding a liquid asset buyer is easier than finding an illiquid one. This is not to say that one should not have illiquid funds but that one should not depend on illiquid funds for emergencies. 

3. Liquidity is an often overlooked attribute 

The value of liquidity in the investment sector is greatly underestimated. In the race to secure the future, many investors do not make a provision for contingencies that may arise at any time. 

Not having this security can force you to dig into your long-term investment plans, defeating their purpose. 

4. Cash retains its value 

To a large extent, illiquid funds manage to hold their value as they hand-trade, unlike many illiquid funds. As a result, you will most likely face a fine when you dive into long-term investments to meet your urgent needs. 

Depending on market conditions, you may or may not receive a price when you sell your property or properties. But when you break access to your savings account, your money won't lose much value. 

When investing in different asset classes, ensure you have enough liquidity to use when needed.

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