Liquidity risk involves the possibility that earnings or capital will be negatively affected by an institution's inability to meet its obligations when they come due. Liquidity risk is the risk that the financial institution cannot settle an obligation for full value when it is due (even if it may be able to settle at some unspecified time in the future). Liquidity problems can result in opportunity costs, defaults in other obligations, or costs associated with obtaining the funds from some other source for some period of time. In addition, operational failures may also negatively affect liquidity if payments do not settle within an expected time period. Until settlement is completed for the day, a financial institution may not be certain what funds it will receive and thus it may not know if its liquidity position is adequate. If an institution overestimates the funds it will receive, even in a system with real-time finality, then it may face a liquidity shortfall. If a shortfall occurs close to the end of the day, an institution could have significant difficulty in raising the liquidity it needs from an alternative source.
Systems that postpone a significant portion of their settlement activity (in dollar terms) toward the end of the day, such as CHIPS, may be particularly exposed to liquidity risk. These risks can also exist in RTGS systems such as Fedwire. As mentioned above, systems or markets that pose various forms of settlement risk also pose forms of liquidity risk. CLS Bank, while eliminating the bulk of principle risk through its payment-versus-payment design, retains significant liquidity risk, as funding is made on a net basis, and pay-in obligations may need to be adjusted in the event that a counterparty is unable to fund its obligations. Other systems, including securities settlement systems, may also be subject to liquidity risks.
To manage and control liquidity risk, it is important for financial institutions to understand the intraday flows associated with their customers' activity to gain an understanding of peak funding needs and typical variations. To smooth a customer's peak credit demands, a depository institution might consider imposing overdraft limits on all or some of its customers. Moreover, institutions must have a clear understanding of all of their proprietary payment and settlement activity in each of the payment and securities settlement systems in which they participate.
Legal (Compliance) Risk