Risk And Liquidity: Portfolio Interplay And Balance

Investors create portfolios to reduce risk and maximise income. Portfolios spread capital across multiple assets, creating diversification and reducing the risk of exposing 100% of invested capital to the outcome of a single asset. However, when analysing a portfolio, there is an area that most investors may not be aware of — the interplay between risk and liquidity.

Liquidity refers to how easily an asset or security can be bought or sold in the market and converted into cash. Liquidity risk, on the other hand, is the potential inability of an individual, company, or investment fund to meet its short-term debt obligations due to the lack of liquid assets. It is the risk that an entity might be unable to trade an asset quickly enough to prevent or minimise a loss.

Understanding the interplay between risk and liquidity in an investment portfolio is crucial for investors to make informed decisions and effectively manage their financial risk exposure.

The impact of market conditions on liquidity risk

Market conditions play a crucial role in determining an investment portfolio's liquidity risk, which is the possibility that an institution or individual will struggle to obtain funds to meet their financial obligations. This risk can be exacerbated by adverse market conditions, such as those witnessed during the global financial crisis (GFC), which highlighted the dangers of a run on the non-depository shadow banking system.

Market liquidity risk, a type of liquidity risk, occurs when an entity cannot execute transactions at current market prices due to insufficient market depth or disruptions. This risk is heightened in illiquid markets, where large transactions can significantly impact prices. For instance, selling a substantial volume of shares in a thinly traded stock could lower the share price, resulting in a loss for the seller.

Market conditions, such as overall market volatility and the demand-supply dynamics of specific assets, influence the ease of converting assets into cash. During periods of financial turbulence, even creditworthy entities may struggle to secure short-term funding on favourable terms, increasing liquidity risk.

Additionally, market microstructure influences liquidity risk. Over-the-counter (OTC) markets, for instance, tend to be thinner and less liquid than exchanges such as commodity futures.

The time horizon also plays a role in liquidity risk. A seller's urgency to exit a position can exacerbate the risk, whereas a patient seller may face a reduced threat as illiquidity issues often resolve with more time.

Furthermore, market conditions can impact the bid-ask spread, a crucial measure of liquidity. A low or narrow bid-ask spread indicates a tight spread, reflecting a more liquid market. Conversely, an abnormally wide bid-ask spread suggests exogenous liquidity risk, where buyers have withdrawn from the market.

Market conditions can also impact the depth of the market, referring to its ability to absorb the sale or exit of a position without significantly impacting the price. For instance, a large institutional investor selling a substantial block of shares in a small-capitalization company will likely cause the share price to fall.

In summary, market conditions, including overall market volatility, asset-specific demand and supply dynamics, market structure, and time horizons, all influence liquidity risk. Adverse market conditions can hinder entities' ability to obtain funds, execute transactions at desirable prices, and realise the value of their assets, increasing the risk of financial instability or even insolvency.

The effect of a financial crisis on liquidity risk

A financial crisis can have a profound impact on liquidity risk, and the relationship between the two can be complex and far-reaching. During a financial crisis, liquidity risk can be amplified and have significant effects on financial institutions, corporations, and individuals.

One of the primary ways a financial crisis affects liquidity risk is by creating a liquidity crisis, which is characterised by a lack of cash or easily convertible assets across many businesses and financial institutions. This can lead to an increase in demand and a decrease in the supply of liquidity, resulting in widespread defaults and bankruptcies. The 2007-2008 financial crisis, for example, led to urgent demands for cash from various sources, including borrowers, short-term creditors, and counterparties.

Financial institutions, such as banks, are particularly vulnerable to liquidity problems during a financial crisis. Their revenue often depends on lending long-term loans, such as mortgages, while relying on short-term funding from depositors. This maturity mismatch can lead to liquidity issues when there is a sudden withdrawal of funds by depositors, as seen during the global financial crisis.

To manage their liquidity risk during a financial crisis, banks may increase their holdings of liquid assets, reduce new lending, and rely more on traditional deposits and equity capital for funding. However, this can have a detrimental effect on borrowers, as it reduces the availability of credit. The impact of liquidity risk on banks during a financial crisis also depends on the nature of the crisis. For example, liquidity risk tends to be more harmful to banks during banking crises, where the health of the industry is a public concern, compared to market crises.

Corporations may also face liquidity risk during a financial crisis, especially if they fund long-term assets with short-term liabilities. Volatile cash flows and delayed payments from customers can further exacerbate liquidity issues. To manage their liquidity risk, corporations may establish revolving credit facilities, maintain cash reserves, and engage in effective cash flow forecasting and management.

In summary, a financial crisis can have a significant impact on liquidity risk by creating a liquidity crisis, affecting financial institutions, corporations, and individuals. The management of liquidity risk during a financial crisis is crucial to prevent defaults, bankruptcies, and a decline in the availability of credit.

Company-specific factors that influence liquidity risk

• Market Conditions: Changes in interest rates, credit availability, and investor sentiment can impact a company's liquidity risk. For instance, an increase in interest rates or tight credit markets may reduce access to funding, increasing liquidity risk. Companies with high debt levels or weak credit profiles are more vulnerable in such situations.
• Lack of Funding: When a company fails to obtain finance at competitive rates, its liquidity risk increases. This may be due to various factors, such as a weak credit profile or limited access to credit facilities.
• Capital Expenditures: Unplanned capital expenditures can affect liquidity risk, particularly in capital-intensive organizations. These businesses often have a high fixed-to-variable cost ratio, which can further increase liquidity risk.
• Management Practices: Effective liquidity risk management, stress testing, and contingency planning are crucial for mitigating liquidity risk. Governance and risk management policies implemented by companies play a significant role in enhancing their liquidity position.
• Asset Management: A well-managed asset management system helps optimize working capital levels and enhance liquidity. This is especially important for companies with significant physical assets.
• Funding Structure: The funding structure of a company, including lines of credit and other financing sources, can impact liquidity risk. A diverse funding structure can reduce liquidity risk by providing alternative sources of funding.

These factors are unique to each company and influence how they manage their liquidity risk. Effective management of these factors is essential to ensure financial stability and meet short-term financial obligations.

Regulatory amendments and their impact on liquidity risk

Regulatory amendments have had a significant impact on liquidity risk management, particularly in the financial sector. The global financial crisis (GFC) brought liquidity risk to the forefront, as it was identified as a contributing factor to the crisis. This prompted regulatory bodies and financial institutions to re-evaluate and strengthen their approach to managing liquidity risk.

One notable example of regulatory amendments is the Basel III framework, developed by the Basel Committee on Banking Supervision. Basel III sets stringent liquidity standards for banks and financial institutions, aiming to enhance their resilience to financial shocks and protect depositors' interests. These standards include the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), which ensure banks maintain sufficient liquid assets to withstand stress scenarios.

In the United States, the Securities and Exchange Commission (SEC) has also implemented amendments to enhance liquidity risk management for open-end management investment companies. These amendments include enhanced disclosure requirements, classification of portfolio investments based on liquidity, and the establishment of liquidity risk management programs. The SEC's rules aim to strengthen the securities markets and better protect investors.

The impact of these regulatory amendments has been significant. Financial institutions now place a higher priority on managing liquidity risk, with a focus on maintaining diverse funding sources and stable deposit bases. The amendments have also led to the development of more robust risk management frameworks that consider liquidity risk from various perspectives, including governance, stress testing, and contingency planning.

While the regulatory changes have improved liquidity risk management, they have also had macroeconomic impacts. For instance, the increased focus on short-term liquidity contracting in the markets has led banks and financial institutions to rely more heavily on their clients' deposits as a source of financing. This, in turn, has influenced the strategies and operations of these institutions, shaping the broader economic landscape.

Strategies for managing liquidity risk

• Ensure compliance with regulatory frameworks that establish minimum liquidity standards. For instance, banks are guided by frameworks like Basel III, which sets stringent liquidity standards to ensure financial stability and safeguard depositors' interests.
• Maintain a portfolio of high-quality liquid assets that can be easily converted to cash without significant loss in value.
• Employ rigorous cash flow forecasting and management. This involves projecting cash inflows and outflows, optimizing payment terms, and ensuring adequate liquidity to meet both expected and unexpected cash flow needs.
• Diversify funding sources to reduce dependency on a single or a few funding channels. This can include a mix of retail deposits, wholesale funding, equity financing, debt financing, trade credit, and other financial instruments.
• Establish contingency funding plans to address potential liquidity shortfalls. These plans outline strategies and actions to be taken during a liquidity crisis, ensuring a structured approach.
• Conduct stress testing to simulate adverse market conditions and identify potential liquidity shortfalls.
• Engage in asset/liability management to balance a bank's assets and liabilities, minimizing liquidity risk.
• For corporations, establish revolving credit facilities with financial institutions to provide a safety net for short-term liquidity needs.
• Maintain cash reserves to buffer against financial duress or unforeseen expenditures, ensuring continuity of operations.
• Unlock 'trapped' cash by utilizing advancements in technology, such as real-time payment technologies, sophisticated APIs, foreign exchange tools, and automation.
• Centralize financial data to improve access, visibility, and management of data, enhancing control over cash flow forecasting.

Frequently asked questions