Liquidity risk refers to the risk that a bank or other financial institution may encounter when it is forced to sell part of its investment portfolio before the investments have reached their maturity. This premature sale could potentially result in a capital loss for the bank. Liquidity risk is a significant concern for financial institutions as they must always be prepared for the possibility of needing to liquidate assets quickly to meet their obligations or to respond to an unexpected event. This risk is inherent in investments that are not easily sold or converted into cash without a substantial loss in value. These include assets like real estate, certain types of securities, and other illiquid investments.

Choice A is incorrect. Credit risk refers to the potential loss that a bank may face when a borrower fails to meet their contractual obligations. It does not refer to the risk associated with selling investments prematurely.

Choice B is incorrect. Business risk pertains to the uncertainty in profits or danger of loss and the events that could pose a risk due to some unforeseen events in future, which causes business to fail. It does not specifically relate to premature sale of investments.

Choice C is incorrect. Default risk, similar to credit risk, refers to the possibility that a borrower will be unable to make required debt payments and thus default on their obligations. This type of risk does not encompass situations where banks are forced into premature sale of their investments.

Things to Remember

• Liquidity risk is a key consideration for banks and financial institutions as it can impact their ability to meet short-term obligations.
• Asset-liability management is crucial in managing liquidity risk effectively.
• Regulatory requirements often mandate that banks maintain a certain level of liquidity to mitigate liquidity risk.
• Market liquidity risk is another aspect to consider, which refers to the risk of not being able to execute large transactions without impacting the market price.
• Contingency funding plans are put in place by banks to address potential liquidity