Final answer:
Liquidity risk refers to the risk of not being able to sell an asset quickly without significantly affecting its price. This can be a problem for banks as they need to meet deposit withdrawals while having assets that take a longer time to be repaid. If a bank faces liquidity risk, it may struggle to sell assets quickly without a significant price impact.
Step-by-step explanation:
Liquidity risk refers to the risk of not being able to sell an asset quickly without significantly affecting its price. It is the risk of an asset not being easily convertible into cash without a significant loss of value.
In the context of the question, liquidity risk is particularly relevant for banks because they have a time mismatch between their liabilities (customer deposits) which can be withdrawn quickly, and their assets (loans and bonds) which are repaid over a longer period of time. If a bank faces liquidity risk, it may struggle to meet deposit withdrawals if it cannot easily sell its assets without a significant price impact.
For example, if a bank has loaned a substantial amount of money at a certain interest rate, but then sees interest rates rise substantially, it may find it challenging to sell its loans quickly without accepting a lower price. This can create a precarious situation for the bank.