How Can Liquidity Risk And Credit Risk Cause Insolvency?

Above-average returns always come with above-average risks. A thorough analysis can reveal the different types of risk that an investment may hold. Knowing the risks within an investment can help investors to manage those risks better. 

Risks have different degrees in how they may adversely impact a portfolio. But do some investments carry risks that can cause insolvency? 

What Are Liquidity and Credit Risks

Liquidity is the ability to convert an asset to cash quickly. When an investor can’t convert an asset to cash quickly, they face liquidity risk. The need to sell a home quickly is a great example of liquidity risk.

Credit risk is the degree to which a borrower can make payments on time, which can result in a loss. Analyzing the financial strength of a borrower can reveal how able they are to make future payments. This analysis consists of looking at the borrower’s financial statements, financial history, current financial situation, exposure to investments, and ability to raise capital.

Some borrowers, such as large corporations, may have credit ratings. This is generally true of public companies. The higher the credit rating, the more likely the company can meet its loan payments and avoid default.

Lenders aren't the only entities that analyze credit risk. Investors should be aware of credit risk as well. For example, when an investor purchases stock in a company, it's important to know the company's credit rating. If the company defaults on a loan or even files for bankruptcy, the investor may lose their entire investment.

Let's now turn to our primary question: how can liquidity and credit risk cause insolvency?

Can Liquidity and Credit Risk Cause Insolvency?

Taking the view of an investor, what happens if they discover their investment has exposure to either of these risks or both?

First, let's go over some quick definitions. Insolvency means a borrower is unable to make debt payments. Insolvency is not the same as debt default. Debt default means that a borrower has gone past a payment due date. Debt default can be a symptom of insolvency. 

We'll use a few examples to go over these various scenarios. Starting with liquidity risk, an investor discovers that they cannot sell an investment at a reasonable (i.e., market) price quickly. The investor needs to raise cash to make debt payments and has no other assets to sell. If the investor sells the asset immediately, its value will be cut by 25-30%, which won't be enough to pay off the debt. 

In this case, the investor will not only be late on payments, but even after selling the investment (at a discount), the investor will not have enough cash to pay off the total debt. The result is the investor will be insolvent because of liquidity risk.

We’ll use the same investor in a similar situation. The investor has an investment that generates enough in monthly distributions to meet their monthly debt payments. The investor does have a job, but all of his income goes towards living costs. 

The company behind the investment has one customer that generates 75% of its income. Due to a change in quality requirements, the customer decides to go with a different vendor. The company/vendor cannot bring in enough income to meet its financial obligations and files for bankruptcy. The investor's entire investment is wiped out.

For our investor, this one investment was his only source of income for monthly debt payments. The investor has no assets that can be sold to raise cash or any other means of meeting his monthly debt payments. The investor has become insolvent due to credit risk.

Can both liquidity and credit risk cause insolvency together? Yes — if one of them can cause insolvency, nothing is preventing both from causing insolvency (assuming both risks are present).

Thorough analysis and constant monitoring of investments can help discover potential liquidity and credit risks. An investment might start off by checking all of the right boxes. However, investments are dynamic. The landscape beneath an investment can change, requiring a new strategy. 

Monitoring the credit rating of an investment can help offload some of the analysis work involved. However, credit ratings aren’t the final word on the quality of an investment. It is still up to the investor to be thorough with each investment.