Liquidity Risk Management

Thota Nagaraju
Dept of Econ & Fin
BITS-Pilani Hyd Campus
Liquidity Risk Management

Thota Nagaraju BITS-Pilani Hyderabad Campus Liquidity Risk Management Second Sem 2023-24 1
Liquidity Risk Management
➢.
➢Role of 2007 financial crisis
➢Solvency versus liquidity
➢Liquidity needs are uncertain
➢Liquidity trading risk

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SBIN Bid-Ask Spread on 1st April 2021 on BSE
➢.

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Smruthi Organics’s Bid-Ask Spread on 1st April 2021 on BSE
➢.

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Liquidity trading risk
The price at which a particular asset can be sold depends on
✓ 1. The mid-market price of the asset, or an estimate of its value
✓ 2. How much of the asset is to be sold
✓ 3. How quickly it is to be sold
✓ 4. The economic environment

➢ Predatory Trading

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Liquidity trading risk
➢The Importance of Transparency
➢Measuring Market Liquidity

The dollar bid-offer spread p= Offer price – Bid price

The proportional bid–offer spread for an asset is defined as

Where Si is an estimate of the proportional bid–offer spread in normal market conditions for the ith financial instrument held by a financial institution.

αi is the dollar value of the position in the instrument.

n is the number of positions.

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Liquidity trading risk- Numerical examples
➢ Suppose that a financial institution has bought 10 million shares of one company and 50 million ounces of a
commodity.
➢ The shares are bid $89.5, offer $90.5.
➢ The commodity is bid $15, offer $15.1.
➢ The mid-market value of the position in the shares is 90 × 10 = $900 million.
➢ The mid-market value of the position in the commodity is 15.05 × 50 = $752.50 million.
➢ The proportional bid–offer spread for the shares is 1∕90 or 0.01111.
➢ The proportional bid–offer spread for the commodity is 0.1∕15.05 or 0.006645.
➢ The cost of liquidation in a normal market is 900 × 0.01111∕2 + 752.5 × 0.006645∕2 = 7.5
or $7.5 million.

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Cost of liquidation in stressed market
➢..

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Cost of liquidation in stressed market – Numerical example
➢ In the previous example, the mean and standard deviation for the bid–offer spread for the shares are $1.0 and
$2.0, respectively.
➢ Suppose further that the mean and standard deviation for the bid–offer spread for the commodity are both $0.1.
➢ The mean and standard deviation for the proportional bid–offer spread for the shares are 0.01111 and 0.02222,
respectively.
➢ The mean and standard deviation for the proportional bid– offer spread for the commodity are both 0.006645.
➢ Assuming the spreads are normally distributed, the cost of liquidation that we are 99% confident will not be
exceeded is
0.5 × 900 × (0.01111 + 2.326 × 0.02222) +0.5 × 752.5 × (0.006645 + 2.326 × 0.006645) = 36.58
or $36.58 million. This is almost five times the cost of liquidation in normal market conditions.

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Other Measures of Market Liquidity
➢The volume of trading per day (i.e., the number of times the asset trades in a day) is an
important measure.
➢When an asset is highly illiquid, the volume of trading in a day is often zero.
➢Amihud (2002) Measure of liquidity.

It is the average of over all days in the period considered.

➢Amihud shows that an asset’s expected return increases as its liquidity decreases.
➢In other words, investors do get compensated for illiquidity.

Y. Amihud, “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects,” Journal of Financial Markets 5 (2002): 31–56.

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Liquidity Funding Risk
➢Liquidity funding risk deals with the financial institution’s ability to meet its cash needs as they arise.
➢Liquidity funding problems at a financial institution can be caused by:
1. Liquidity stresses in the economy
2. Overly aggressive funding decisions
3. A poor financial performance, leading to a lack of confidence.

➢Sources of Liquidity
1. Holdings of cash and Treasury securities
2. The ability to liquidate trading book positions
3. The ability to borrow money at short notice
4. The ability to offer favorable terms to attract retail and wholesale deposits at short notice
5. The ability to securitize assets (such as loans) at short notice
6. Borrowings from the central bank

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Liquidity Funding Risk - Reserve Requirements
➢.

➢The role of Money multiplier

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Liquidity Funding Risk - Regulation
Basel Norms III
Basel III introduced two liquidity risk requirements: the liquidity coverage ratio (LCR) and the net stable funding ratio
(NSFR).

1) The LCR requirement is

The 30-day period considered in the calculation of LCR is one of acute stress involving a downgrade of three notches (e.g., from AA+ to A+), a
partial loss of deposits, a complete loss of wholesale funding, increased haircuts on secured funding, and drawdowns on lines of credit. LCR was
implemented in stages between 2015 and 2019. (The required ratio was 60% in 2015 and 100% in 2019.)

2) The NSFR requirement is

The numerator is calculated by multiplying each category of funding (capital, wholesale deposits, retail deposits, etc.) by an available stable
funding (ASF) factor, reflecting their stability. The denominator is calculated from the assets and off-balance sheet items requiring funding. Each
category of these is multiplied by a required stable funding (RSF) factor to reflect the permanence of the funding. The implementation date for
the NSFR requirement is January 1, 2018.

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How banks should manage liquidity
➢Following the liquidity crisis of 2007,bank regulators issued a revised set of
principles on how banks should manage liquidity. These are as follows:
1. A bank is responsible for the sound management of liquidity risk.
2. A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role
in the financial system.
3. Senior management should develop a strategy, policies, and practices to manage liquidity risk in accordance
with the risk tolerance and to ensure that the bank maintains sufficient liquidity.
4. A bank should have a sound process for identifying, measuring, monitoring, and controlling liquidity risk.
5. A bank should establish a funding strategy that provides effective diversification in the sources and tenor of
funding.
6. A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered
assets.
7. A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing
liquidity shortfalls in emergency situations.
8. A bank should publicly disclose information on a regular basis that enables market participants to make an
informed judgment about the soundness of its liquidity risk management framework and liquidity position.
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Liquidity Black Holes
➢A liquidity black hole describes a situation where liquidity has dried up in a particular
market because everyone wants to sell and no one wants to buy, or vice versa.
➢It is sometimes also referred to as a “crowded exit.”

In a well-functioning market, the market may change its opinion about the price of an asset because of new information.
However, the price does not overreact. If a price decrease is too great, traders will quickly move in and buy the asset and a new
equilibrium price will be established. A liquidity black hole is created when a price decline causes more market participants to
want to sell, driving prices well below where they will eventually settle. During the sell-off, liquidity dries up and the asset can be
sold only at a fire-sale price.

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Liquidity Black Holes - Positive and Negative Feedback Traders
There are two sorts of traders in the market: negative feedback traders and positive feedback
traders.
Negative feedback traders buy when prices fall and sell when prices rise;
Positive feedback traders sell when prices fall and buy when prices rise.
There are a number of reasons why positive feedback trading exists. For example:
1) Trend trading
2) Stop – loss rules
3) Dynamic hedging
4) Creating options synthetically
5) Margins
6) Predatory trading

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Liquidity Black Holes - Leveraging and Deleveraging
➢Leveraging leads to more borrowing throughout the economy”
The period leading up to 2007 was characterized by leveraging for many of the world’s economies.

Leveraging Deleveraging

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Liquidity Black Holes - Irrational Exuberance

➢ The term “irrational exuberance” was used by Alan Greenspan, Federal Reserve Board chairman, in a speech in
December 1996 when, in reference to the stock market, he asked, “How do we know when irrational exuberance
has unduly escalated asset values?” (The phrase has been remembered because the speech was followed by
declines in stock prices worldwide.)
➢ Most liquidity black holes can be traced to irrational exuberance of one sort or another.
➢ The classic example of what has been described above is the subprime crisis that started in 2007.
➢ Other examples are the 1987 stock market crash, the 1994 bond market crash, the 1997–1998 Asian monetary
crisis, and
➢ the 1998 Long-Term Capital Management failure.
➢ Irrational exuberance is part of human nature and to some extent is inevitable.

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Liquidity Black Holes - The Impact of Regulation
➢.

➢All banks tend to respond in the same way to external events.

➢Consider for example market risk. When volatilities and correlations increase, market risk
VaR and the capital required for market risks increase.
➢Banks then take steps to reduce their exposures.
➢Since banks often have similar positions to each other, they try to do similar trades. A
liquidity black hole can develop.

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Liquidity Black Holes - The Importance of Diversity
➢.
➢Models in economics usually assume that market participants act independently of each
other.
➢But from the practical life, it is know that this is often not the case. It is this lack of
independence that causes liquidity black holes.

Partial Solutions
1) Hedge Fund (but it fails because of its leverage and in stressed markets, they have to windup their positions)
2) Contrarian Investment Strategy (it is not suitable if Short-term VaR is implemented in the FIs)

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