Financial institutions do not always fail because of the inability to generate a profit. Rather, it's the inability to meet short-term financial obligations that often leads to bankruptcy. This is known as funding liquidity risk. Suppose Tohonday decides to invest in long-term assets, in that case, it must take into account its day-to-day funding requirements, especially because funds invested in long-term assets cannot be realized quickly enough to meet short-term debts and other unforeseen obligations, such as lawsuits. Northern Rock, a significant UK mortgage lender, encountered a severe funding liquidity crisis in 2007, a situation that signaled the onset of the global financial crisis. The bank heavily relied on wholesale markets instead of depositor funds to finance its mortgage lending, a strategy that backfired amidst the global credit crunch triggered by the US subprime mortgage crisis. With most of its assets tied up in long-term mortgages, Northern Rock found itself unable to liquidate these assets swiftly enough to meet its short-term obligations, particularly the short-term debts it had incurred to finance long-term loans. This liquidity crisis led to the first bank run in the UK in over a century, resulting in a loss of customer confidence, a government bailout, and eventually nationalization in February 2008.

A is incorrect. Trading liquidity risk (also called market liquidity risk) is the risk associated with the inability of a firm to execute transactions at the prevailing market price. It may reduce the institution's ability to hedge market risk, and also it is the capacity to liquidate assets when necessary.

C is incorrect: Interest rate risk is the risk that arises from fluctuations in the market interest rates, which may cause a decline in the value of interest-rate-sensitive portfolios.

D is incorrect: Market risk is the risk that results due to movements in market prices and rates.

Things to Remember

• Funding liquidity risk is particularly important for firms dealing with differentiated investment timelines, such as shifting from short-term to long-term investments.
• Historical examples such as the Northern Rock crisis in 2007 are crucial case studies