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Chapter 26: Problem 3

How can investment banks be subject to liquidity problems?

Short Answer

Expert verified
Investment banks can be subject to liquidity problems due to asset illiquidity (unable to sell assets quickly at their full value), funding liquidity (liabilities maturing faster than assets causing inability to meet immediate obligations), and market liquidity (inability to sell assets quickly without significantly affecting the market price).

Step by step solution

01

Understand What Is Meant by Liquidity

Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price.
02

Explain Asset Illiquidity and Its Impact on Investment Banks

Asset illiquidity occurs in situations where assets cannot be sold quickly without incurring a significant loss in value. Investment banks often invest in diverse financial instruments, some of which are illiquid. If an investment bank needs to sell these assets quickly (to meet immediate cash demands), it may not get the full value for these assets leading to a shortfall in cash.
03

Describe Funding Liquidity and Its Effect on Investment Banks

Funding liquidity refers to the ability of the investment bank to satisfy its obligations as they come due. If an investment bank's liabilities mature faster than its assets, it can lead to a funding liquidity risk. This is because the bank must now find other sources of cash to meet its obligations.
04

Discuss Market Liquidity and Its Consequences on Investment Banks

Market liquidity refers to the ability to transact in the market without affecting the market price. If there is a lack of market liquidity, an investment bank may not be able to sell assets quickly without drastically affecting the asset price. This can also lead to liquidity problems.
05

Summarize the Role of Liquidity Problems in Investment Banks

In conclusion, investment banks, due to their nature of operations, can be subject to liquidity problems arising from asset illiquidity, funding liquidity and market liquidity.

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