What is capital risk and liquidity risk?
Liquidity and Capital Risk is generally defined as the risk associated with an enterprise's ability to convert an asset or security into cash to prevent a loss. Capital risk is generally defined as an enterprise's access to cash at any given time and balancing this with its efficient use.
Capital risk is the potential of loss of part or all of an investment. It applies to the whole gamut of assets that are not subject to a guarantee of full return of original capital.
Liquidity risk is the risk of loss resulting from the inability to meet payment obligations in full and on time when they become due. Liquidity risk is inherent to the Bank's business and results from the mismatch in maturities between assets and liabilities.
A bank needs capital to absorb losses so as to protect more senior creditors from losses. Put simply, capital risk is the risk that a bank doesn't have enough capital. There are several types of capital, each with different risk characteristics such as CET1, Additional Tier 1, and Tier 2 capital.
Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk.
Capital risk reflects the ability to lose part or all of an investment. It refers to the entire asset gamut that is not subject to a complete return guarantee for original capital. When investing in stocks, non-governmental bonds, real estate, commodities, and other alternative assets, investors face capital risk.
Capital risk relates to the ability to absorb losses, losses can be incurred due to credit risk, liquidity risk etc. However, credit risk is the probability that the borrowers will default on paying the money back.
Liquidity is a bank's ability to meet its cash and collateral obligations without sustaining unacceptable losses. Liquidity risk refers to how a bank's inability to meet its obligations (whether real or perceived) threatens its financial position or existence.
An example of liquidity risk would be when a company has assets in excess of its debts but cannot easily convert those assets to cash and cannot pay its debts because it does not have sufficient current assets. Another example would be when an asset is illiquid and must be sold at a price below the market price.
It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.
Is capital risk a financial risk?
Capital risk refers to a form of financial risk relating to investing. It refers to the possibility of losing some or all of the invested capital due to various market factors.
It is calculated by dividing a financial institution's total adjusted capital by its risk-weighted assets (RWA). The risk-adjusted capital ratio allows comparisons across different geographical locations, including comparisons across countries.
Liquidity is the risk to a bank's earnings and capital arising from its inability to timely meet obligations when they come due without incurring unacceptable losses. Bank management must ensure that sufficient funds are available at a reasonable cost to meet potential demands from both funds providers and borrowers.
Management of liquidity risk is critical to ensure that cash needs are continuously met. For instance, maintaining a portfolio of high-quality liquid assets, employing rigorous cash flow forecasting, and ensuring diversified funding sources are common tactics employed to mitigate liquidity risk.
The OCC has defined nine categories of risk for bank supervision purposes. These risks are: Credit, Interest Rate, Liquidity, Price, Foreign Exchange, Transaction, Compliance, Strategic and Reputation. These categories are not mutually exclusive; any product or service may expose the bank to multiple risks.
There are many ways to categorize a company's financial risks. One approach for this is provided by separating financial risk into four broad categories: market risk, credit risk, liquidity risk, and operational risk.
Capital Adequacy Ratio (CAR) is the ratio of a bank's capital to its risk. It is also known as the Capital to Risk (Weighted) Assets Ratio (CRAR). In other words, it is the ratio of a bank's capital to its risk-weighted assets and current liabilities.
The capital-to-risk weighted assets ratio, also known as the capital adequacy ratio, is one of the most important financial ratios used by investors and analysts. The ratio measures a bank's financial stability by measuring its available capital as a percentage of its risk-weighted credit exposure.
Economic disruptions
Liquidity risk increases when such economic disruptions render businesses unable to meet cash flow and collateral needs under normal and stressed conditions.
- The absence of a sufficient “safety buffer” to cover overall expenses (the most unexpected ones in particular);
- Difficulty finding necessary funding on the credit market or on financial markets.
Why do banks face liquidity risk?
Reasons that banks face liquidity problems include over-reliance on short-term sources of funds, having a balance sheet concentrated in illiquid assets, and loss of confidence in the bank on the part of customers. Mismanagement of asset-liability duration can also cause funding difficulties.
- The current ratio or working capital. This compares current assets, including inventory, and liabilities.
- The acid test, or quick ratio. This measures only current assets, such as cash equivalents, against liabilities.
- The cash ratio or net working capital.
The fundamental role of banks typically involves the transfor- mation of liquid deposit liabilities into illiquid assets such as loans; this makes banks inherently vulnerable to liquidity risk. Liquidity-risk management seeks to ensure a bank's ability to continue to perform this fundamental role.
- Step up your liquidity monitoring. ...
- Review pro-forma cash flow analysis, and stress test your cash flows. ...
- Understand your funding risks. ...
- Review your contingency funding plan (CFP) ...
- Get an independent review of your liquidity risk management.
Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. Cash is the most liquid of assets, while tangible items are less liquid. The two main types of liquidity are market liquidity and accounting liquidity.
