Liquidity risk occurs when an individual investor, business, or financial institution cannot meet its short-term debt obligations. The investor or entity might be unable to convert an asset into cash without giving up capital and income due to a lack of buyers or an inefficient market. Banks and financial institutions are particularly vulnerable to this kind of liquidity problem because much of their revenue is generated by lending long-term loans for home mortgages or capital investments and borrowing short-term from depositor's accounts.
Financial institutions faced the following threats during the liquidity crisis that's are given below:
· The liquidity risk of banks arises from funding long-term assets with short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk.
· The liquidity risk is closely linked to other dimensions of the financial structure of the financial institution, like the interest rate and market risks, its profitability, and solvency, for example.
· Having a larger amount of liquid assets or improving the matching of asset and liability flows reduces the liquidity risk, but also its profitability. This relationship also operates in the opposite direction: loans in an irregular situation will impact jointly on profitability and liquidity, as the expected cash flows do not appear.
· Liquidity spreads have an impact on banks' earnings. The degree of impact depends on the sensitivity of the client rates on deposits and loans towards the liquidity spread movements.
· Excess Liquidity creates interest risk and vulnerable fund management