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Liquidity Risk
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Introduction
Liquidity risk means not being able to meet short-term financial obligations without losses, especially in tough markets. In investment planning, this happens when there isn’t enough cash or liquid assets to cover withdrawals, capital calls, or emergencies. This can force investors to sell assets at lower prices. Recent changes in India, like the RBI’s updated liquidity rules for digital deposits and adjustments to the Cash Reserve Ratio (CRR), highlight the need for effective liquidity management.
Why Liquidity Risk Management is Crucial
Good liquidity management helps maintain financial resilience and operational continuity. For example, the RBI’s draft norms for 2025 require banks to hold 15 percent liquidity cover for unstable digital deposits. A bank with ₹100 crore in such deposits must keep ₹15 crore in high-quality liquid assets (HQLA). Family offices and institutional investors also face growing liquidity risks due to falling private equity distributions and market volatility. They should implement stress-tested liquidity measures to manage cash flow during equity drawdowns or interest rate hikes. Ignoring liquidity risk can lead to bigger problems. The 2024 NBFC liquidity crisis showed the risks of poor liquidity planning. Many firms struggled to meet obligations, leading to a market wide credit freeze.
Challenges of Liquidity-Centric Strategies
Holding liquid assets reduces risk but comes with trade-offs. Focusing too much on liquidity can cut returns.
Low-risk instruments, like RBI bonds and AAA-rated corporate debt, yield only 6.5 to 7.2 percent in 2025, often below inflation, which is 5.9 percent for Q1 2025.
Regulatory limits can also restrict flexibility. The RBI’s CRR adjustments require banks to set aside ₹4.5 to ₹6 lakh crore in reserves each year, limiting their lending capacity and dynamic liquidity management.
Illiquidity is a concern for high-net-worth investors. Many portfolios are heavily invested in private equity and real estate, which usually have lock-in periods of three to five years. This makes exiting difficult during financial crises.
Strategies to Mitigate Liquidity Risk in 2025
Dynamic liquidity buffers help maintain financial flexibility. A balanced portfolio should keep 10 to 15 percent in highly liquid assets, like Treasury bills or overnight reverse repos. This ensures compliance with the RBI’s Liquidity Coverage Ratio (LCR). For example, an institution managing ₹100 crore in stable deposits should keep ₹10 crore in liquidity reserves.
Scenario modeling prepares for market stress. Tools like liquidity guardrail analysis can project cash shortfalls during extreme conditions, such as a 30 percent drop in SME loan repayments or delayed private equity exits.
Diversifying across liquid and illiquid assets is key. While 70 to 80 percent of portfolios may be long-term investments, REITs (yielding 6 to 8 percent) and money market funds (averaging returns of 7.1 percent) offer liquid options that support cash flow stability.
Regulatory alignment aids smoother liquidity management. Banks that follow the RBI’s Net Stable Funding Ratio (NSFR) guidelines, which require securing ₹90 to ₹95 in stable funding for every ₹100 in long-term assets, can reduce liquidity mismatches.
Final Thoughts
Liquidity risk is crucial for financial stability, especially as digital banking and private market investments grow. The evolving regulatory framework in 2025 brings new challenges. However, proactive liquidity management, guided by RBI rules and global best practices can balance safety and long-term growth.
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