What is liquidity risk? How to effectively manage business

Liquidity risk can seriously affect business performance and corporate reputation. Identifying, analyzing causes and developing an effective risk management strategy are vital factors to ensure solvency and maintain sustainable operations. Refer to our article below to better understand liquidity risk and how to manage it effectively in business.

What is liquidity risk? Causes of liquidity risk

Liquidity risk is a situation in which a business or financial institution does not have enough resources to meet payment obligations when due, or can only fulfill these obligations at a higher cost than usual. According to Clause 14, Article 2 of Circular 13/2018/TT-NHNN, this is one of the key risks in the financial sector.

Main causes of liquidity risk:

• Ineffective capital management: Unbalanced use of capital, focusing on long-term investments without short-term capital to meet liquidity.
• Sudden change in payment demand: Large withdrawal demand from customers or unexpected sharp increase in payment costs.
• Lack of capital diversification: Relying too much on one specific source of funding or financial partner.
• Impairment of asset value: Assets cannot be converted into cash promptly due to market freeze or severe devaluation.
• Unstable economic environment: Economic recession, rising interest rates or market fluctuations limit the ability to mobilize capital.

Impact of liquidity risk on businesses and investors

Liquidity risk not only affects the ability of businesses to maintain operations but also directly impacts the decisions and financial benefits of investors. Specifically:

For businesses:

• Loss of investment opportunities: When lacking liquid capital, businesses cannot take advantage of profitable investment opportunities.
• Increased financial costs: Due to having to borrow short-term with higher interest rates to meet immediate payment needs.
• Negative impact on reputation: When not paying on time, businesses easily lose trust from partners, customers and investors.
• Bankruptcy risk: Prolonged liquidity risk causes businesses to lose their ability to operate, leading to the risk of having to close.

For investors:

• Loss of investment value: The value of shares of a business experiencing liquidity risk may decline sharply in the market.
• Risk of capital loss: In case the business cannot recover, investors may suffer the loss of their entire investment capital.
• Concerns: Liquidity risks reduce confidence in the market, leading to an overall decline in liquidity across the stock market.

Effective liquidity risk management strategy

Effective liquidity risk management is a key factor to help businesses maintain financial stability, ensure solvency and optimize investment opportunities in a volatile business environment. Effective liquidity risk management strategies can include:

1. Develop a comprehensive liquidity plan:

• Evaluate net liquidity position (NPL) periodically to identify liquidity deficit or surplus.
• Aim to maintain NPL at a balanced or positive level.

2. Diversify capital sources:

• Combine the use of capital sources from banks, bonds, investment funds and equity capital.
• Strengthen cooperation with many different financial partners to reduce dependence on a single source.

3. Maintain high liquid assets:

• Increase the proportion of assets that can be quickly converted into cash such as stocks, monetary funds, or other short-term assets.
• Ensure compliance with the solvency ratio according to legal regulations.

4. Stress testing:

• Perform periodic checks to forecast liquidity risks in adverse scenarios such as financial crisis or market volatility.
• Determine the tolerance limit of cash flow to promptly develop preventive measures.

5. Make a contingency plan:

• Set up a liquidity reserve fund to use in case of emergency.
• Develop a quick action plan, including selling assets or raising additional capital in the short term.

Liquidity management according to the provisions of Article 48 of Circular 13/2018/TT-NHNN:

• Sufficient high-liquidity assets to ensure safety under normal and adverse business conditions.
• Determine the costs associated with raising capital in the event of a crisis.
• Ensure compliance with the solvency ratio and the ratio of outstanding loans to total deposits.

Consulting on liquidity risk issues

Long Phan’s consulting services help businesses understand the process and handle necessary procedures. Support services from Long Phan include:

• Analyze and evaluate liquidity risks, identify risk sources, assess the level of impact and propose appropriate solutions.
• Build strategy: Design solutions suitable for each business model, focusing on optimizing liquidity.
• Advise on liquidity management policies and processes, propose internal processes and effective management tools.
• Support compliance with regulations related to liquidity risk management, especially in the banking and finance sectors.
• Consulting on risk prevention solutions: Providing measures to minimize and control risks in the long term.

Liquidity risk is a major challenge but can be controlled through effective and appropriate management strategies. To receive detailed advice on liquidity risk management and financial solutions, please contact Long Phan via the hotline 0906735386 for support.