What is a significant consequence of high liquidity risk?

What is a significant consequence of high liquidity risk?

• A. Increased profitability for the bank
• B. The inability to meet short-term financial obligations
• C. Enhanced customer trust in the bank
• D. Improved customer loan offerings

Answer: (B)

High liquidity risk signifies a situation where a financial institution may struggle to convert assets easily into cash without facing substantial losses. This can arise when a bank has a heavy reliance on illiquid assets or insufficient cash reserves. A significant consequence of high liquidity risk is the inability to meet short-term financial obligations. When a bank cannot efficiently obtain cash for its immediate liabilities—such as withdrawing deposits, paying creditors, or covering operational costs—it risks financial instability and may face serious repercussions, including regulatory scrutiny or loss of customer confidence. In contrast, increased profitability is often not associated with high liquidity risk; rather, it's usually a sign of effective cash management. Additionally, enhanced customer trust tends to stem from strong risk management practices rather than high liquidity risk. Finally, improved customer loan offerings would likely necessitate a stable liquidity position to confidently meet the demands of borrowers, which is contrary to the concept of high liquidity risk. Hence, understanding the direct effects of liquidity risk highlights why the inability to meet short-term financial obligations stands out as the correct answer.

High liquidity risk signifies a situation where a financial institution may struggle to convert assets easily into cash without facing substantial losses. This can arise when a bank has a heavy reliance on illiquid assets or insufficient cash reserves. A significant consequence of high liquidity risk is the inability to meet short-term financial obligations. When a bank cannot efficiently obtain cash for its immediate liabilities—such as withdrawing deposits, paying creditors, or covering operational costs—it risks financial instability and may face serious repercussions, including regulatory scrutiny or loss of customer confidence.

In contrast, increased profitability is often not associated with high liquidity risk; rather, it's usually a sign of effective cash management. Additionally, enhanced customer trust tends to stem from strong risk management practices rather than high liquidity risk. Finally, improved customer loan offerings would likely necessitate a stable liquidity position to confidently meet the demands of borrowers, which is contrary to the concept of high liquidity risk. Hence, understanding the direct effects of liquidity risk highlights why the inability to meet short-term financial obligations stands out as the correct answer.