Liquidity Risk in Financial Institutions
Several institutions offer financial services to the populace. These include those that take deposits and issue loans (banks), Insurance companies and brokerage firms. The degree of liquidity risks in banks is a result of a balance between assets and liabilities. It is appropriate to acknowledge that in banks liabilities are more liquid in comparison to assets. A bank can therefore fail to engage in its daily operations as a result of this phenomenon. An illustration is seen when the creditworthiness of a bank is at its lowest thus leading to withdrawals termed as emergencies by the customers. This highlights the need for consistent cash flows within such organizations thus reducing problems that may arise due to liquidity. The degree of liquidity risk in banks as an organization that receives deposits and issues loans is therefore high (Roorda, 2009).
The degree of liquidity risks in insurance companies comes about due to the difficulty of assurance as a result of inadequate funds. This position may be created by a change in financial position due to the need to offer new premiums that are lowly priced, such an occurrence emanates from increases in surrender value caused by cancellations of orders. It is important to note that to reverse such a position an insurance company may be forced to sell off its assets to maintain stability in cash flow. This is in addition to operating with rates that are considerably low about those stipulated in the market thus the term market liquidity risk. A need, therefore, arises to control the market factors to avoid a possible drop in an organization’s profitability. The liquidity position of an insurance company needs to be high to meet liabilities; this feat can be achieved through strategic management. In relation to banks the degree of liquidity risks is low as insurance companies are not depository in nature (Anaesoronye, 2009).
The ability of brokerage firms to conform to proper liquidity management practices determine their ability to reduce the risks associated with liquidity. Brokerage firms provide information that is considered personalized. This service does not require the transfer of cash on a regular basis thus such an organization is unlikely to benefit from an effective cash flow system. These firms carry out orders as per the instructions of the customers; such institutions are also not depository in nature thus exhibiting the lowest degree of liquidity risk among financial institutions.
Rise of Liquidity risk
The processes recorded in balance sheet valuation determine the existence and subsequent progression of liquidity risks. The financial transactions documented either on the asset or liability side determines the rise of liquidity. The asset side of the balance sheet record transactions that involve the transfer of funds to an asset. This is evident in loans and other forms of credit. The liability side of the balance sheet records transactions that come about due to issuing of funds or cash as a result of claims made by customers in insurance companies. These transactions involve the withdrawal of funds thus the rise in liquidity risks.
It is appropriate to acknowledge the role played by cash flow problems in the rise of liquidity risks as it makes it difficult for organizations to meet their financial needs. Mismatches between liabilities and assets are also a source of liquidity risks (Jorion, 2007).
Anaesoronye, M. (April). Boosting liquidity of insurance companies through strategic investment. Business Day. Web.
Jorion, P. (2007). Financial Risk Manager Handbook. John Wiley and Sons.
Roorda, B. (2009). Liquidity risk in financial institutions. CTIT.