Liquidity risk is the most difficult to manage in a banking system. The biggest problem is the inability to ascertain when and where such a risk is going to occur. The banks in Japan failed to understand the importance of `stress testing' under different scenarios of `back-end testing'. The overlapping of market, credit, operational and liquidity risks was never clear and resulted in crisis. Lack of `stress test' in Indian banks under different scenarios also indicates that long-term strategic contingency planning is not in place.

Liquidity is crucial to the ongoing viability of any banking organization. Banks' capital positions can have an effect on their ability to obtain liquidity, especially in a crisis. Banks must have adequate systems for measuring, monitoring and reporting liquidity risk. They should evaluate the adequacy of capital given their own liquidity profile and the liquidity of the markets in which they operate.

It is idiosyncratic or bank-specific which can vary from bank to bank depending on the maturity pattern and canonical relation between the assets and the liabilities. This can also happen if the bank's credit rating gets downgraded or continuous withdrawal of deposits takes place taking the bank under stress, resulting in other banks or counterparties to avoiding trading with or lending to the bank. This can also be termed as lack of funding. Liquidity crisis prevents a bank from raising sufficient funds when there is a need to meet its payment obligations.

It occurs when selling a financial instrument becomes difficult. Some experts also define such risk as the risk that an entire system or market is devoid of liquidity during periods of crisis or high volatility. For instance, the US stock market crash of 1987 and Long-Term Capital Management (LTCM) episode of 1998. For details on wide variety of Systematic Liquidity Crisis refer the Box.

Professional Banker Magazine, Liquidity Risks, Banking System, Liquidity Crisis, Long-Term Capital Management, LTCM, Risk Management, Asset Liability Management, Non-Performing Assets, NPAs, Accounting Practices, Liquidity Strategy, Public Sector Unit, PSU.