Understanding Liquidity Risk
Liquidity Risk by 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 unacceptable 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 to 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 securities 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 fungibility1
Liquidity risk has been a major factor in many crises impacting both credit risk and
market 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 analysis 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 react,
thus a pre-established plan is useful.
1
Condition of being replaceable.