Liquidity determines whether an asset can be sold in the market within a reasonable timeframe without losing its value. Liquidity risk describes the risk associated with the inability to sell an investment quickly in cash. The liquidity risk will emerge when the intermediary has assets that cannot be converted into liquid funds quickly and hence requires the banks to make the payments. An unexpected withdrawal of funds or loss of insurance coverage may trigger a situation like this.
As a result of an earthquake, fire, flood, or hurricane, a company incurs unexpectedly high claim losses. All intermediaries may suddenly be in need of funds. Despite this, depository institutions are particularly vulnerable to deposit runs caused by a deposit run that can cause financial crisis due to their low reserves and long-duration liabilities.
Liquid assets can reduce liquidity risk by allowing the intermediary to quickly convert them into the funds necessary to meet unexpected withdrawal contingencies. The intermediary can also make other arrangements to reduce this risk. These backup lines of credit can be used in case of an emergency.
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