Liquidity Risk
The risk of being unable to sell an asset quickly at a fair price, or of being unable to meet financial obligations as they come due.
What is Liquidity Risk?
Liquidity risk exists in two related forms. Asset liquidity risk is the danger that a security or asset cannot be sold quickly without a significant price concession — common in less-traded bonds, small-cap stocks, real estate, and alternative investments. Funding liquidity risk is the inability of a firm or individual to meet financial obligations as they come due, either because assets cannot be quickly converted to cash or because credit markets are closed. During financial crises, asset liquidity risk and funding liquidity risk reinforce each other: falling asset prices force leveraged sellers to liquidate, which further depresses prices and dries up market liquidity. Bid-ask spreads, trading volume, and market depth are common proxies for asset liquidity.
Example
During the 2008 financial crisis, structured credit products such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) became nearly impossible to sell at any price as buyers disappeared. Banks holding these assets faced funding liquidity risk — they could not use illiquid assets as collateral for short-term borrowing. This forced fire sales that further depressed prices, creating a negative feedback loop that the Federal Reserve ultimately broke by providing emergency liquidity through unprecedented programs.
Source: BIS — Liquidity Risk Management