Question

Solvency is obviously important to any company. Even the financial crises of 2008-2009 were partly due to some liquidity risk and to this day we are still learning more about. Financial institutions rely on some form of cash for difficult times. Briefly discuss one real example of liquidity risk and also listing a pro and a con to that example.

Answer 1

A real example of liquidity risk is bank deposits and loans.

Banks take in deposits from customers and the same are loaned out to various borrowers. In this situation the bank is taking a liquidity risk. This is because it is assuming that all customers will not require the withdrawals at the same time.

The advantage of this liquidity risk is that the bank is able to make profits by loaning out the amount that it has collected in the form of deposits.

The disadvantage of this is that in case there are more withdrawals than estimated, the bank will be at a risk of bankruptcy as it will not be able to repay the deposits made by customers.