Liquidity Risk
Joseph A. Iraci
Liquidity risk is a key source of financial risk, and liquidity refers to the speed within which an
asset can be converted into cash. In addition to converting assets to cash, firms use a variety of
other tools to manage liquidity risk including lines of credit, securitizations, and money market
activity.
The Basel Committee on Banking Supervision has not instituted formal capital charges to
cover liquidity risk because liquidity is less suited to formal risk measurement. However, the
Basel Committee stated “Liquidity is crucial to the ongoing viability of any banking organization.
Bank’s capital positions can have an effect on their ability to obtain liquidity, especially in a crisis.”
The ability to liquidate assets to generate cash is very dependent on market conditions, and
these conditions impact bid / ask spreads and liquidation time horizon.
Lack of liquidity can cause a firm to fail even when it is technically solvent (assets being
greater than liabilities). Liquidity is the life blood of financial services, and lack of liquidity can
cause a run on any financial firm as clients seek to get their cash. Liquidity risk consists of both
asset liquidity risk and funding liquidity risk. The Committee of European Banking Supervisors
defines them as:
• Asset Liquidity Risk: Also called market / product liquidity risk. It is the risk that a position
cannot easily be unwound or offset at short notice without significantly influencing the
market price, because of inadequate market depth or market disruption.
• Funding Liquidity Risk: It is the current or prospective risk arising from an institution’s
inability to meet its liabilities and obligations as they come due without incurring unac-
ceptable losses.
These risks interact and impact a portfolio that contains illiquid assets that may have to be
sold at distressed prices to raise funding. Assessing liquidity risk starts with understanding
market conditions. The bid / ask spread measures the cost of buying and selling an amount
within a normal market size. A market that has high liquidity will have a narrow bid / ask spread.
For example, the US Treasury market. Conversely, a market that has low liquidity will have a
wider bid / ask spread. For example, the junk bond market. The US Treasury market has much
more depth than does the junk bond market thus its spread is very narrow.
When a market lacks depth, large transactions can impact the market and liquidity can vary
greatly across asset classes and can vary by security type. For example, liquidating illiquid secu-
rities generally is still much faster than trying to liquidate real estate. Asset liquidity risk depends
on several factors:
• Market conditions
• Liquidation time horizon
• Asset and security type
• Asset fungibility
1
Liquidity risk has been a major factor in many crises impacting both credit risk and mar-
ket risk. Funding liquidity risk arises from the liability side, for both on-balance sheet and off-
balance sheet items. Liabilities can be classified as core or volatile, where each term refers to
the predictability of cash flows. For example, if a bank relies on statement savings accounts for
funding, it has stable funding when compared to a bank that relies on certificates of deposit
that come from brokers. Funding gaps can also be met by asset sales. Cash and liquid assets
provide a cushion that can be used to support funding needs.
Liquidity risk should have adequate governance structures and tools in order to measure,
monitor, and manage liquidity risk. There is no single measure of liquidity risk, firms typically
use a range of metrics to assess liquidity risk. Liquidity risk management, however, usually
starts with operational liquidity, which establishes the daily cash needs by forecasting all cash
inflows versus outflows. Once operational liquidity is assessed, the next step is usually an anal-
ysis of a firm’s access to unsecured funding sources and the liquidity profile of its asset base.
This information is integrated into a strategic perspective that looks at current assets, current
liabilities, and off-balance sheet items.
A funding matrix is built that shows funding needs for various maturities. Any funding gap
should be addressed by plans to raise additional liquidity through either borrowing or asset
sales. A contingency funding plan establishes a plan of action should one of the liquidity stress
scenarios develop. When a crisis hits, management usually has no time to react, thus a pre-
established plan is useful.