Liquidity Risk

Liquidity risk is the risk that an institution will be unable to meet its obligations when they fall due, or that it will be able to do so only at excessive cost. Liquidity risk is distinct from solvency risk, which concerns the adequacy of the assets relative to the liabilities.

Funding Liquidity Risk

Funding liquidity risk is the risk that an institution cannot obtain the funds required to meet its obligations. It arises when the institution relies on short-term funding that may not be rolled over, or when the sources of funding are disrupted.

The risk is inherent in the business of banking, since banks hold illiquid assets and liquid liabilities. A loss of confidence can prompt depositors and other creditors to withdraw their funds, forcing the bank to sell assets at a loss or to seek emergency funding.

The management of funding liquidity risk involves the diversification of the sources of funding, the holding of liquid assets, and the maintenance of contingent funding arrangements. The design of these arrangements affects the resilience of the institution to stress.

Market Liquidity Risk

Market liquidity risk is the risk that an asset cannot be sold quickly at a fair price. It arises when the market for the asset is thin, when there are few buyers, or when the conditions in the market are disrupted.

The risk is measured by the difference between the price at which an asset can be sold and its fundamental value, and by the time required to sell it. The measures are imperfect, and the risk can change rapidly, particularly during periods of stress.

Market liquidity risk is related to funding liquidity risk. When markets become illiquid, institutions may find it difficult to sell assets to raise funds, and the two risks interact in a way that can amplify stress.

Regulation

The regulation of liquidity risk has been strengthened since the financial crisis. The framework includes quantitative requirements, including the liquidity coverage ratio, which requires institutions to hold sufficient liquid assets to meet their obligations over a short period, and the net stable funding ratio, which addresses the stability of funding over a longer period.

The framework also includes qualitative requirements, including the requirement for institutions to have a liquidity risk management framework and a contingency funding plan. The framework is complemented by supervisory review, which assesses the liquidity risk of individual institutions.

The regulation of liquidity risk has implications for the business of banking. The requirements raise the cost of maturity transformation, which may reduce the supply of credit and the profitability of banks. The design of the regulation must balance the benefits of stability against the costs to intermediation.

Systemic Dimension

Liquidity risk has a systemic dimension, since the failure of one institution to meet its obligations can affect others. The interconnection of the financial system means that a liquidity shock can spread, and the markets themselves can become illiquid as institutions seek to sell assets simultaneously.

The systemic dimension provides a rationale for the central bank to act as lender of last resort and for the regulation of liquidity at the systemic level. The design of the framework must take account of the interactions among institutions and of the potential for contagion.

The Interaction of Funding and Market Liquidity

The interaction between funding liquidity risk and market liquidity risk is central to the analysis of financial stability. When institutions face funding pressures, they may be forced to sell assets, which depresses their prices and further impairs the liquidity of the market.

This interaction can create a spiral, in which the decline in asset prices raises the losses of the institutions, which prompts further sales, which drives prices down further. The spiral can turn a liquidity problem into a solvency problem and can spread across the financial system.

The analysis of the spiral is central to the understanding of financial crises. It explains why liquidity can evaporate quickly and why the intervention of the central bank may be required to restore the functioning of the market.

Liquidity Regulation

The regulation of liquidity risk has been strengthened since the financial crisis. The framework includes the liquidity coverage ratio, which requires institutions to hold sufficient high-quality liquid assets to cover their net outflows over a thirty-day stress period, and the net stable funding ratio, which requires institutions to fund their long-term assets with stable sources of funding.

The requirements have raised the cost of maturity transformation, which is the core business of banking. The assessment of the effects must consider both the benefits of the increased resilience and the costs to the provision of credit.

The framework also includes requirements for the measurement and the management of liquidity risk, including the conduct of stress tests and the maintenance of contingency funding plans. The framework is complemented by supervisory review.

Liquidity and the Central Bank

The central bank plays a central role in the management of liquidity risk. It provides liquidity to the banking system through its operations and acts as the lender of last resort during periods of stress.

The design of the framework for the provision of liquidity affects the behaviour of institutions. A framework that provides liquidity freely may encourage excessive risk-taking, while a framework that is too restrictive may leave institutions exposed to runs. The design must balance these considerations.

The central bank also influences liquidity through its collateral framework, which determines the assets that it is willing to accept in its operations. The design of the framework affects the liquidity of the assets themselves and the behaviour of institutions.

Summary

Liquidity risk arises from the mismatch between illiquid assets and liquid liabilities, and it has both a funding and a market dimension. The regulation of liquidity and the role of the central bank are central to the management of the risk.

See also

• Banking
• Bank Liquidity Crisis
• Lender of Last Resort