|13-3-2017 | Lionel Pavey |
There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In today’s article I will focus on liquidity risk. Many companies have very significant credit needs and this needs to be formally addressed with a credit analysis procedure in place. In my former articles I dealt with risk management, interest rate risk, foreign exchange risk, commodity risk and credit risk. See the complete list at the end of today’s article.
Liquidity risk comes in 2 distinct forms – market liquidity risk and funding liquidity risk.
Market Liquidity Risk
This relates to assets and potential illiquidity in the market and, as such, can be considered a market risk. In a normal functioning market it is always possible for market participants (buyers, sellers, market makers and speculators) to find each other and negotiate a price for their transactions. Assuming that the transaction is of a normal market size, there should be no dramatic change to the price of the asset after the transaction.
At the time of a crisis, participants could be absent from the market, making it difficult – if not impossible – to trade an asset. Sellers are left frustrated as there are no opportunities to sell the asset they are holding and vice versa for buyers. This can occur due to a financial crisis, changes in legislature, scarcity of an asset or someone attempting to corner the market. An asset generally will have a value, but if there are no buyers in the market that value can not be realised.
Liquidity risk is not the same as falling prices – after all prices are free to rise or fall. If an asset was priced at zero then it means that the market considers its value to be nothing. This is different from trying to sell an asset but not being able to find a buyer.
Markets for Foreign Exchange, Stocks, Shares, Bonds and many Futures and other derivatives are generally highly liquid. Off balance sheet products related to physical settlement can be less liquid as there is a need to actually provide physical settlement. Bespoke products like CDO’s can be considered illiquid as their size is normally small (relatively speaking) and not freely tradeable. Also the complexity needed to value the product affects its liquidity.
Housing is an asset class with very low liquidity – sometimes a property could be sold as soon as it hits the market. At other times the same property could be available for sale for many years and the price reduced regularly, without attracting a firm buyer.
The easiest and quickest way to see if there is a heightened market liquidity risk is via the bid – offer spread. If this is suddenly seen widening, this would imply that there appears to be more risk. In a normal, liquid market, the spreads are fairly constant and small, allowing participants to easily step in and transact. A widening of spreads occurs in a normal market when government data is published – nonfarm payrolls, balance of payment, etc. Within a short time the market will return to a normal spread as the information is properly digested and the market makers return. However, if the spreads widen without a publication event taking place, it is reasonable to assume that the risk has increased.
Additionally, risk could grow if reserve requirements were increased. In markets such as Futures, it is necessary to pay margin to the exchange. If these margin payments were increased, this would lead to transactions being more expensive and so lead to less liquidity in the market.
Market makers can also observe the market depth. This is shown by the quantity available for transacting at a particular price in their order books. When a market is perceived as being deep, it means there are many orders and, therefore, a large number of orders would be needed to move the market price significantly. The deeper the market, the more liquid the market.
Funding Liquidity Risk
This relates to the risk of not being able to settle debts when they are due. Treasury specialists in a corporate environment are acutely concerned with funding risk. Every month wages must be paid, together with tax and social premiums (pensions, insurance etc.) Additionally, it would be advantageous to pay trade creditors on time. Future liabilities also have to be funded after they have been recognized. This could mean arranging external financing.
If there is a liquidity crisis in the market, it becomes difficult and expensive to arrange to borrow the necessary funds. The price may be so high that the intended profit provided by selling the goods, is negated by the increased cost of funding. A reduction in the credit rating of a company can also lead to increased costs and a reluctance to lend.
If a company is known to have problems making payments, then the liquidity risk is specific to the company – the rest of the market will function normally.
Funding risk can also occur if creditors fail to pay you, or if an unforeseen event has occurred that leads to an outflow of cash from the company.
A company can initially perform a quick spot check to ascertain its current ratio. This shows if a company can meet its current liabilities with its current assets. A ratio of less than 1 would imply that the company can not meet all its obligations at the same time. However, this could also be because there is no short term finance arranged at that moment.
It is possible to arrange a line of credit with a financial provider. He defines a maximum loan (line of credit) that can be extended which the company may utilize. While it is normal to pay a standing charge for the balance of the line that is not being used, this can be offset by the knowledge that it is possible to drawdown against the line when needed (in normal circumstances). There is greater flexibility with a line of credit than with a traditional bank loan.
Other methods include –
i) Sell assets like stock that are slow moving and tying down cash
ii) Analyse all overheads – office equipment, expense claims
iii) Increase efficiency in the debtors’ administration. Be proactive
iv) Renegotiate with suppliers – better that you talk to them before it is too late
v) Design contingency plans
vi) Subject your business to stress testing
vii) Apply the techniques of ALM (asset and liability management)
Some very well known companies have fallen to liquidity problems – Bear Sterns, Lehman Brothers, Northern Rock, ABN Amro, AIG, etc. While the risks were prevalent before the crises, the main liquidity problems occurred when it was determined that there was no more time allowed for the situation to remain.
Time is the soul of business.
Cash Management and Treasury Specialist
More articles of this series: