Credit Risk Vs. Liquidity Risk
Liquidity risk refers to the chance that an entity will have an insufficient cash flow to meet its obligations. This can be caused by the undesirability of an asset in the marketplace, such as a company’s products or fixed assets set for liquidation.
Credit risk is the risk of loss due to non-payment of debts owed by an entity. Credit risk may be compounded by liquidity risk.
- Commercial banks tend to attract short-term deposits.
- They often lend for longer periods of time e.g. in the form of a business loan or a housing mortgage.
- To reduce liquidity risk banks will try to attract longer-term deposits and also hold some liquid assets as capital reserves.
- This is the risk to the commercial bank of lending to borrowers who turn out to be unable to repay their loans.
- It can be controlled by proper safeguards/research into the credit-worthiness of borrowers.
- It also controlled through prudential regulation i.e. the size of reserves banks must hold back in case of bad debts.