Liquidity Spirals and Financial Distress
We have examined the difficulties that can arise with asset and funding risks, and extend the theme in this chapter by analyzing instances of financial distress that can arise from joint asset/funding liquidity problems. We know from previous chapters that difficulties in raising funding or selling/pledging assets can produce losses. While such losses can be serious, widespread financial damage can generally be contained. However, in some cases asset and funding difficulties combine to create a much more dire scenario. Specifically, when asset and funding liquidity risks join together, a liquidity spiral — or a cycle where attempts to secure additional liquidity come at an increasing cost and a decreasing level of flexibility — can develop. Once a liquidity spiral has commenced, each new attempt to source cash becomes more critical, difficult, and costly. A company caught in a spiral must deal forcefully with the crisis or risk sliding into financial distress and possible insolvency.
KeywordsFinancial Distress Credit Rating Agency Liquidity Problem Financial Flexibility Asset Sale
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