National Check Professional (NCP) Certification Practice Test

What is Liquidity Risk?

1. The risk of not being able to sell investments quickly

2. The risk that a financial institution cannot meet its obligations when due without incurring unacceptable losses

3. The risk of fluctuating interest rates

4. The risk of clients defaulting on loans

The correct answer is: The risk that a financial institution cannot meet its obligations when due without incurring unacceptable losses

Liquidity risk refers to the possibility that an entity may not be able to meet its short-term financial obligations due to an inability to convert assets into cash without facing significant losses. This definition aligns perfectly with the choice that focuses on the challenges faced by a financial institution when it cannot fulfill its debts as they come due. Liquidity risk is crucial for financial stability because it indicates how easily a company can access cash to honor its commitments. In contrast, the other options present different types of risks. For example, the choice about the inability to sell investments quickly reflects market liquidity risk, which is a subset of liquidity risk but does not encompass the broader implications for financial obligations. The choice on fluctuating interest rates relates to interest rate risk, which can impact cash flows and asset valuations but is distinct from liquidity concerns. Finally, the risk of clients defaulting on loans pertains to credit risk, focusing on the borrower's ability to repay debts rather than the institution's capacity to maintain liquidity. Thus, recognizing liquidity risk as the risk of failing to meet obligations without incurring significant losses helps outline its pivotal role in maintaining a financially sound institution.