Liquidity Risk in India

Liquidity risk—sounds technical, but it’s actually something you experience every day, even if you don’t know it. In a country like India, where the economy is growing fast but still vulnerable to shocks, liquidity risk is something you can’t afford to ignore. So, let’s break it down. What is liquidity risk? When does it pop up? And why should it matter to you, whether you’re a student or a professional in the financial world?

What is Liquidity Risk?

Liquidity risk occurs when you are unable to get cash or assets quickly enough to pay your debts. You may have assets, but they are isolated somewhere, and you cannot convert them into cash when you need it most. This is a major issue in business and finance. If a corporation, a bank, or even you as a person do not have liquidity, you are in trouble.

Liquidity is more than simply having money; it also means having access to it. Banks and corporations prioritize cash flow and assets that can be quickly sold or utilized to pay payments. This risk is especially significant in India’s fragile economy, given how quickly things may change owing to political unrest, economic downturns, or worldwide market collapses.

When Does Liquidity Risk Arise?

Liquidity risk arises when there is an unexpected requirement for cash that is not accessible for any reason. It might occur when firms are unable to sell their products, banks are unable to satisfy withdrawal requests, or global variables such as interest rates or inflation disturb regular financial processes. In India, this is especially typical when unforeseen occurrences, such as the 2016 demonetization move or the COVID-19 outbreak, disrupt the market.

For instance, when a business in India overestimates its revenue or underestimates the market demand, it can run into liquidity problems because the cash flow simply isn’t there. It’s like having a wallet full of credit cards, but you need real cash, and your cards aren’t doing the job.

Types of Liquidity Risks

Market Liquidity Risk

Market liquidity risk is about how easy (or hard) it is to sell something at a fair price. It happens when there’s no one around to buy what you’re selling or when there’s no market for your asset. Think about real estate in India, for example. You may own property, but when the market crashes, no one’s buying, and you can’t sell it without taking a huge loss.

In illiquid markets, like small stocks or certain types of bonds, prices fluctuate wildly. When things go bad, it’s a nightmare. If you can’t sell quickly enough, you might have to lower the price just to get someone to buy.

Funding Liquidity Risk

Funding liquidity risk is when you can’t raise money to meet your short-term obligations. This happens when you can’t borrow, or borrowing becomes too expensive. Banks in India face this risk when they can’t secure enough funds to meet withdrawals, and businesses face it when they can’t get loans to keep operations running.

During the IL&FS crisis in 2018, many non-banking financial companies (NBFCs) in India faced severe funding liquidity risks because they could no longer access the credit they needed to operate. A sudden shortage of available funds can cause a company to default, leading to a domino effect in the economy.

Liquidity Risks and Banks

Banks are ground zero for liquidity risk. Banks accept deposits and provide loans. They must have adequate liquidity to fulfill withdrawal needs while simultaneously retaining sufficient capital for lending. But what happens if there is a sudden run on the banks? Consider a scenario in which everyone rushes to withdraw their money at once. If the bank does not have adequate cash or liquid assets.

In India, the financial system is more sensitive to liquidity risks due to the growing number of non-performing assets (NPAs). When these assets pile up, they block cash flow and drain liquidity. If a bank can’t access enough cash to meet its daily obligations, it faces a crisis. The Reserve Bank of India (RBI) often steps in to provide liquidity, but the damage is done by then.

Liquidity Risks and Bank Runs

A bank run is the ultimate nightmare for banks. It happens when customers start rushing to withdraw their money, fearing that the bank might collapse. Even though banks usually don’t have all their deposits in cash, the mere fear of a collapse can drain them dry.

In India, a sudden loss of trust in a bank, whether due to a financial scandal or a downturn in the market, can trigger a wave of withdrawals. The more people fear the bank will fail, the more likely a bank run will happen. And once it starts, it’s tough to stop. It can even lead to the collapse of the bank if liquidity isn’t managed well.

Liquidity Risks and Corporations

Corporations in India, particularly small and medium-sized enterprises (SMEs), are often the most vulnerable to liquidity risk. SMEs usually don’t have deep pockets or a wide range of financing options, so they rely on credit lines, loans, or trade credit to manage daily operations. When markets tighten or customers delay payments, these businesses can get stuck without cash.

Think of it this way: if you own a small business and your clients delay payments, you might struggle to pay your suppliers or employees. This can snowball into bankruptcy if not managed properly. Many businesses in India have collapsed under the weight of liquidity risk, especially during the COVID-19 pandemic, when supply chains broke, and demand shrank.

 Why is Liquidity Risk Important?

The liquidity risk is a building period catastrophe. If not properly handled, it has the potential to bring down whole financial institutions, such as banks, firms, and even economies. For India, where financial inclusion is increasing but remains fragile, liquidity risk may generate market panic, hurting everyone from tiny enterprises to huge institutions.

Liquidity crises also impact investor confidence. When liquidity is low, stocks become volatile, bonds lose their value, and markets can crash. If you’re an investor in India, understanding liquidity risk can help you dodge financial bullets and make smarter decisions.

Questions to Understand your ability

Q1.) What is liquidity risk?

a) When someone fails to repay a loan

b) When you can’t turn your assets into cash fast enough

c) When inflation eats away at your savings

d) When the debt agreement is messed up

Q2.) Funding liquidity risk looks like…

a) A company can’t sell off its assets at a fair price

b) A bank’s broke because it can’t meet withdrawal demands

c) A business going bankrupt due to a bad investment

d) A loan being downgraded to junk status

Q3.) What happens during a bank run?

a) Customers start running to deposit money in the bank

b) Everyone rushes to withdraw their cash because they think the bank’s about to crash

c) The bank’s stock prices skyrocket

d) The economy becomes super liquid

Q4.) How does liquidity risk mess with corporations, especially SMEs?

a) SMEs just get more investments when liquidity is low

b) They can’t pay their bills because customers are slow to pay and markets tighten

c) Corporations become cash-rich when liquidity risk hits

d) Liquidity risk makes SMEs more financially stable

Q5.) Why should India be seriously worried about liquidity risk?

a) Because it’s only a problem for big corporations

b) The country’s financial system is vulnerable and shaky, especially during market shocks

c) It’s a problem just for banks and not anyone else

d) India’s interest rates are super low, so no one cares

Conclusion

Liquidity risk is real, and it’s everywhere—from banks to businesses, to the stock market. In India, where financial markets are expanding and evolving quickly, understanding liquidity risk is crucial. Whether it’s market liquidity, funding liquidity, or liquidity risks tied to banks and corporations, if things go wrong, the ripple effect is massive.