Liquidity risk

Sergio Scandizzo and Tony Hughes

INTRODUCTION

The 2008 financial crisis underscored the critical importance of liquidity risk in the functioning of financial markets and institutions. During the crisis, a widespread freeze in global financial markets caused financial institutions severe difficulties in selling assets or obtaining funding, leading to a liquidity crisis. We witnessed runs on banks and other institutions as depositors and investors sought to withdraw their funds due to concerns about the institutions’ solvency. At the same time, as one institution faced liquidity problems, it had a domino effect, spreading the risk throughout the financial system. This interconnectedness amplified the impact of liquidity risk on a systemic level. Central banks around the world had to intervene aggressively to inject liquidity into the financial system. Programmes such as quantitative easing and emergency lending facilities were implemented to stabilise markets and prevent a complete collapse of the financial system.

The crisis prompted a reassessment of risk management practices in financial institutions as many of them had underestimated the potential for liquidity risk and relied too heavily on short-term funding