What is liquidity risk and how is it linked to interest rate and credit risks? What is

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What is liquidity risk and how is it linked to interest rate and credit risks? What is the role of asymmetric information in creating liquidity risk?

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Liquidity risk is the risk the FI faces in being unable to satisfy claims against its assets without impairing its financial or reputational capital Information asymmetry is at the heart of liquidity problems A random shock to the term structure can induce a deposit outflow which may necessitate a sale of some assets loans But due to asymmetric information the FI may only be able to sell them for less than what it thinks they are worth thus creating liquidity risk With respect to default risk since the depositors know less about the quality of the FIs loan portfolio unfavorable perceptions of it can prevent new deposits from flowing into the FI This can also create liquidity risk Liquidity risk manifests itself in the institution being unable to replace maturing liabilities at reasonable cost It results in a drying up of funds making it difficult for the institution to keep investing in its asset ...View the full answer

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