What are the two reasons liquidity risk arises? How does liquidity risk arising from the liability side of the balance sheet differ from liquidity risk arising from the asset side of the balance...

What are the two reasons liquidity risk arises? How does liquidity risk arising from the liability side of the balance sheet differ from liquidity risk arising from the asset side of the balance sheet? What is meant by fire-sale prices?

Liquidity risk arises due to a liability-side reason and an asset-side reason. Liability-side risk is when the liability holders of an FI seek to cash in their financial claims immediately. The sudden claim or withdraw from liability holders, such as insurance customers and depositors, prompts the FI to borrow the funds or sell assets to pay for the claim or withdraw. Since most of the FIs funds are gaining interest in investments that are less liquid than cash, cashing the investments in are more costly. A depository institution knows that under normal circumstances, only a small portion of its deposits will be withdrawn on any given day and that new deposits may offset the outdraw of cash. Asset-side liquidity risk is the demand for liquidity on the assets-side once an FI has funded a loan commitment. While liability-side risk arises from the demand to fund the withdrawal, asset-side liquidity is the demand to fund the loan on the balance sheet immediately thus increasing demand for liquidity.

Fire-sale prices is the price received for an asset that had to be liquidated easily, which may be far less than it would have received from negotiating a sale.

Saunders, A., & Millon Cornett, M. (2011). Financial institutions management: A risk management approach (7th ed.). New York, NY: McGraw-Hill/Irwin.