First approach

Introduction: different types of liquidity
The concept of liquidity is used in two quite different ways. It is used in one way to
describe financial instruments and their markets. A liquid market is one made up of
liquid assets; normal transactions can be easily executed – the US treasury market
for on-the-run bonds is an especially good example. Liquidity is also used in the
sense of the solvency of a company. A business is liquid if it can make payments
from its income stream, either from the return on its assets or by borrowing the
funds from the financial markets.
The liquidity risk we consider here is about this second kind of liquidity. Financial
institutions are particularly at risk from a liquidity shortfall, potentially ending in
insolvency, simply due to the size of their balance sheets relative to their capital.
However, a financial institution with sufficient holdings of liquid assets (liquid in the
sense of the first type) may well be able sell or lend such assets quickly enough to
generate cash to avoid insolvency.
The management of liquidity risk is about the measurement and understanding of
the liquidity position of the organization as a whole. It also involves understanding
the different ways that a shortfall can arise, and what can be done about it. These
ideas will be explored in more depth in the following sections.
Liquidity of financial markets and instruments
It would seem straightforward to define the concept of market liquidity and the
liquidity of financial instruments.
A financial market is liquid if the instruments in this market are liquid, a financial
instrument is liquid if it can be traded at the ‘market price’ at all times in normal or
near-normal market amounts.