Liquidity Risk

What is Liquidity ?
• Definition and Importance
• Liquidity: The ability to meet financial obligations as they come due without incurring
unacceptable losses
• For banks, liquidity represents the capacity to:
• Fund increases in assets
• Meet liabilities when they mature
• Execute customer withdrawal requests
• Satisfy collateral demands
• Support normal business operations
• In simpler terms, liquidity is a measure of how quickly and easily assets can be
converted into cash to pay for immediate and short-term liabilities.
• Why Liquidity Matters
• Acts as the lifeblood of financial institutions
• Enables day-to-day operations and long-term strategic planning
• Insufficient liquidity can lead to institutional failure even when technically solvent
• The 2007-2008 financial crisis demonstrated how quickly liquidity can evaporate
Types of Liquidity
• Market Liquidity
• Definition: The ease with which an asset can be sold without causing a significant movement in price
• Characteristics:
• Trading volume and frequency
• Bid-ask spread (narrow = higher liquidity)
• Market depth (ability to absorb large orders)
• Market resilience (speed of price recovery after large orders)
• Funding Liquidity
• Definition: The ability of a bank to meet its obligations as they come due
• Components:
• Access to sufficient cash reserves
• Ability to borrow in interbank markets
• Capacity to monetize assets (convert to cash)
• Stable deposit base
• Diverse funding sources
• The Interconnection
• Market and funding liquidity often reinforce each other in a crisis
• Market illiquidity → Funding challenges → Forced asset sales → Further market illiquidity
What is Liquidity Risk ?
• Definition
• Liquidity Risk: The risk that a bank will be unable to meet its obligations when due without
incurring unacceptable losses
• Key Drivers of Liquidity Risk
• Maturity transformation (borrowing short-term, lending long-term)
• Customer behavior (deposit withdrawals, loan drawdowns)
• Market conditions (stress, panic, contagion)
• Bank-specific reputation concerns
• Systemic issues affecting multiple institutions
• Manifestation of Liquidity Risk
• Inability to fund normal operations
• Excessive costs to meet obligations
• Forced sale of assets at distressed prices
• Inability to meet regulatory requirements
• In extreme cases: bank runs and institutional failure
Types of Liquidity Risk
• Funding Liquidity Risk
• Risk that the bank cannot meet expected and unexpected current and future cash flow
needs
• Examples: Deposit runs, inability to roll over maturing debt, credit line drawdowns
• Market Liquidity Risk
• Risk that a bank cannot easily offset or eliminate a position without significantly affecting the
market price
• Examples: Widening bid-ask spreads, market freezes, disappearance of buyers
• Intraday Liquidity Risk
• Risk that a bank cannot manage its intraday funding requirements
• Examples: Timing mismatches in payment systems, settlement failures
• Contingent Liquidity Risk
• Risk arising from off-balance sheet commitments and obligations
• Examples: Credit line draws, margin calls, contractual triggers
Basel III Regulatory Framework
Overview
• Why Basel III Was Necessary
• 2007-2008 financial crisis exposed severe weaknesses in bank liquidity management
• Previous regulatory focus was primarily on capital adequacy, not liquidity
• Many banks had insufficient high-quality liquid assets
• Over-reliance on short-term wholesale funding proved dangerous
• Basel III Liquidity Framework Goals
• Strengthen banks' ability to withstand liquidity stress
• Improve short-term resilience of banks' liquidity risk profiles
• Promote longer-term structural balance in funding profiles
• Enhance risk management and supervision practices
• Key Liquidity Components
• Liquidity Coverage Ratio (LCR): Short-term resilience measure
• Net Stable Funding Ratio (NSFR): Longer-term structural measure
• Monitoring Tools: Additional metrics to assess liquidity risk
• Supervisory Standards: Principles for sound liquidity risk management
Liquidity Coverage Ratio (LCR)
• Purpose
• Ensures banks have sufficient high-quality liquid assets (HQLA) to survive a 30-day stress scenario
• Promotes short-term resilience to liquidity shocks
• LCR Formula
• LCR = ( ) ≥ 100%
• High-Quality Liquid Assets Categories
• Level 1 Assets (no haircut): Cash, central bank reserves, high-quality sovereign debt
• Level 2A Assets (15% haircut): Certain government securities, covered bonds
• Level 2B Assets (25-50% haircut): Corporate debt securities, certain equities
• Implementation Timeline
• Phased in from 2015 (60%) to 2019 (100%)
• Now fully implemented globally in most jurisdictions
LCR Calculation Example
• Scenario
• Bank ABC has the following:
• Cash and central bank reserves: $200 million
• AAA-rated government bonds: $300 million
• High-quality corporate bonds (A+ rated): $100 million
• Expected cash outflows over 30 days: $750 million
• Expected cash inflows over 30 days: $250 million
• Calculation
• 1. HQLA Calculation:
• Level 1: $200m + $300m = $500m (no haircut)
• Level 2A: $100m × 0.85 = $85m (after 15% haircut)
• Total HQLA: $500m + $85m = $585m
• 2. Net Cash Outflows:
• Total outflows: $750m
• Total inflows (capped at 75% of outflows): Min($250m, $750m × 0.75) = $250m
• Net cash outflows: $750m - $250m = $500m
• 3. LCR:
• LCR = $585m / $500m = 117%
• Conclusion
• Bank ABC's LCR exceeds the minimum requirement of 100%, indicating adequate short-term liquidity .
Net Stable Funding Ratio (NSFR)
• Purpose
• Encourages banks to fund activities with more stable sources of funding on an ongoing basis
• Reduces reliance on short-term wholesale funding
• Addresses funding mismatches and incentivizes banks to fund long-term assets with long-term
liabilities
• NSFR Formula
• NSFR = ( ) ≥ 100%
• Key Components
• Available Stable Funding: Capital, long-term debt, stable deposits
• Required Stable Funding: Based on assets and off-balance sheet exposures
• Implementation
• Introduced as a minimum standard in January 2018
• Requires banks to maintain stable funding relative to the liquidity of their assets and activities
NSFR Calculation Example
• Scenario
• Bank XYZ has the following:
• Liabilities and Capital:
• Regulatory capital: $150 million (ASF factor: 100%)
• Stable retail deposits: $400 million (ASF factor: 95%)
• Less stable retail deposits: $200 million (ASF factor: 90%)
• Unsecured wholesale funding (1-year maturity): $300 million (ASF factor: 100%)
• Short-term wholesale funding (<6 months): $250 million (ASF factor: 50%)
• Assets:
• Cash and central bank reserves: $100 million (RSF factor: 0%)
• Government securities: $250 million (RSF factor: 5%)
• Residential mortgages (>1 year): $600 million (RSF factor: 65%)
• Corporate loans (<1 year): $200 million (RSF factor: 50%)
• Corporate loans (>1 year): $150 million (RSF factor: 85%)
• Calculation
• 1. ASF Calculation:
• $150m × 100% + $400m × 95% + $200m × 90% + $300m × 100% + $250m × 50% = $1,065m
• 2. RSF Calculation:
• $100m × 0% + $250m × 5% + $600m × 65% + $200m × 50% + $150m × 85% = $592.5m
• 3. NSFR:
• NSFR = $1,065m / $592.5m = 180%
• Conclusion
• Bank XYZ's NSFR significantly exceeds the minimum requirement of 100%, indicating strong structural funding stability.
Practical Liquidity Risk Management
• Key Strategies for Banks
• Diversification of funding sources
• Multiple funding channels, markets, instruments, and maturities
• Avoid overreliance on any single source
• Robust contingency funding planning
• Clearly defined early warning indicators
• Predefined action plans for various stress scenarios
• Regular testing and updating
• Liquidity buffer management
• Maintain adequate high-quality liquid assets
• Balance cost of liquidity against risk appetite
• Integrated risk assessment
• Consider interactions between liquidity risk and other risks
• Incorporate liquidity costs in pricing and product development
"Liquidity is oxygen for a financial system... When it's
present, nobody notices. When it's absent, everybody
notices."

Mervyn King, former Governor of the Bank of England