Liquidity Risk and Northern Rock

Today, we’ll look at the issue of liquidity risk. Liquidity is always used in finance to refer to cash. There are three types of cash in businesses: cash on hand, cash inflow, and cash outflow. Cash in hand refers to money that hasn’t been invested or pledged to pay off debts. Cash inflow refers to the money a company receives from selling goods or providing services. The funds used by a business to purchase raw materials, pay employees, pay rent, and settle debts with creditors are referred to as cash outflow.

Cash in hand rises as cash inflow rises; however, when cash outflow exceeds cash inflow, cash in hand falls. Negative cash in hand occurs when cash outflows exceed cash inflows over a long period of time. The two options for dealing with liquidity risk are bank overdrafts and trade agreements. A thriving business will always have reliable banks where they can deposit their earnings and conduct transactions, allowing them to apply for bank overdrafts in times of need. Banks will look over their transaction history and come up with a way to lend to this company at a specific interest rate so that the funds can be used to solve the company’s liquidity issues. Companies, on the other hand, enter into agreements with their suppliers to pay for services and goods. Suppliers are required to wait another 90 days or more for payment in exchange for a higher interest rate or a bonus from the company under the terms of the agreements. Always remember that in order to make a profit for the creditors, cash must be used in the business. As a result, no one will freely give money and one should pay a rate of interest to complete the transaction. As a result, companies increase their financial burden in order to eliminate liquidity risk within a certain time frame, or else their financial burden will intensify liquidity risk.

In 2008, a real-life example of liquidity risk occurred. Northern Rock Bank is a major bank in England and is best known for owning the Newcastle team in the English Premier League. During the 2008 financial crisis, they faced liquidity risk due to bad mortgage loans, but they couldn’t use bank overdrafts or trade agreements because no counterparties could afford to give a huge sum of 26 billion euros as of January 2008. As a result, Northern Bank turned to the Bank of England for help. Northern Rock’s stock plummeted by 90% as a result of this news, and the company’s liquidity risk further increased. Northern Rock Bank declared bankruptcy and defaulted as a result.

Companies will hire certified enterprise risk actuaries to deal with liquidity risk issues before they arise. CERA will use data from the company and data that interacts with risks, such as interest rates, CPI (consumer price index), PMI (purchase manager index), and inflation, as well as historical cash flows and cash in hand, to perform scenario analysis and predictive analytics. Then they’ll create a mathematical model to predict future inflows and outflows so they can figure out how much cash the company will need to deal with these issues. They’ll even conduct stress testing, which assumes no cash inflow for an extended period of time, to determine the best cash on hand to deal with adverse situations. Many companies in Covid have recently experienced cash inflow shortages, and some have defaulted, while others have dealt with the situation with prior planning by their risk management team.

Thank you for reading this article; I hope to see you again soon with another financial article.