The liquidity risk that arises systemwide. This refers to the risk associated with simultaneous liquidity difficulties (stress) being faced by multiple institutions within the system. It captures the negative effects (externalities or systemic risks) that are generated individually by each entity (a bank or financial institution) as to certain liquidity stress events.

Systemic liquidity risk represents the tendency of financial institutions, operating in the same system, to collectively underprice liquidity risk when funding smoothly flows in and out because such institutions expect that the central bank will always intervene in times of stress to maintain such flows, prevent the collapse of financial institutions, and thus limit or mitigate any potential impact of liquidity shortfalls on the entire system.

If a central bank fails to tackle such shortfalls during times of systemic stress, the negative effects or externalities may be reinforced, and financial institutions would be spurred to keep holdings of lower liquidity buffers than normal levels, further driving systemic liquidity risk to a higher boundary.

In a system, liquidity risk can arise in two key forms: market liquidity risk and funding liquidity risk. The former is the risk that an institution will not be able to sell an asset quickly without incurring a material reduction its price; while the latter constitutes the risk that an institution will not be able to expediently raise funds in order meet current or future expected cash flow requirements.

Through the market dynamism, these two types of liquidity risk can play out, interact and affect the entire system. A negative spiral between the two types can take shape whereby a sudden lack of funding would prompt several institutions to sell their assets simultaneously to secure the much-needed cash. In turn, this leads to a sort of correlated fire sales of assets in the system, possibly driving up lending rates (margin and haircuts), and negatively impacting the value of assets posted as collateral. A self-reinforcing cycle can create  downward pressures on asset prices and may deteriorate institutions’ equity and capital, developing into a systemwide crisis as multiple institutions come under similar pressures.