Liquidity risk includes the inability to manage unplanned decreases or changes in funding sources. Liquidity risk also arises from the failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value. This can be done by:. There are many causes of liquidity risk liquidity risk actually arises when the one party wants to trading an asset cannot do it because in the market no one wants to trade that asset.
Liquidity is the ability of a firm, company, or even an individual to pay its debts without suffering catastrophic losses. It is typically reflected in unusually wide bid-ask spreads or large price movements. Common knowledge is that the smaller the size of the security or its issuer, the larger the liquidity risk. This rush to the exits caused widening bid-ask spreads and large price declines, which further contributed to market illiquidity.
Before the global financial crisis GFC , liquidity risk was not on everybody's radar. Financial models routinely omitted liquidity risk. But the GFC prompted a renewal to understand liquidity risk. They did this indirectly but undeniably by increasing collateral haircuts.