Liquidity Risk and Credit Risk (Financial Economics)

This short study note looks at the difference between liquidity risk and credit risk in the financial sector.

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
• As a result, a commercial bank may not be able to repay all of those deposits if savers decide to withdraw their funds
• To reduce liquidity risk banks will try to attract longer term deposits and also hold some liquid assets as capital reserves

Credit risk

• This is the risk to the commercial bank of lending to borrowers who turn out to be unable to repay their loans
• Credit risk can be controlled by proper safeguards / research into the credit-worthiness of borrowers
• Credit risk also controlled through prudential regulation i.e. the size of reserves banks must hold back in case of bad debts

One of the key features of the UK and many other countries is a high level of personal sector debt. This carries risk both for the financial sector and the wider economy.

Risks of high household debt

1. Sudden fall in incomes e.g. due to an economic downturn
2. Unexpected rise in interest rates on existing debts especially mortgage borrowing

Both 1 and 2 could cause a significant squeeze on consumers’ ability to service their debts