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Understanding Liquidity Risk
Before the global financial crisis (GFC), liquidity risk was not on everybody's radar. Financial models routinely omitted liquidity risk. But the GFC prompted a renewal to understand liquidity risk. One reason was a consensus that the crisis included a run on the non-depository, shadow banking system—providers of short-term financing, notably in the repo market—systematically withdrew liquidity. They did this indirectly but undeniably by increasing collateral haircuts.
After the GFC, all major financial institutions and governments are acutely aware of the risk that liquidity withdrawal can be a nasty accomplice in transmitting shocks through the system—or even exacerbating contagion .
- Liquidity is how easily an asset or security can be bought or sold in the market, and converted to cash.
- There are two different types of liquidity risk: Funding liquidity and market liquidity risk.
- Funding or cash flow liquidity risk is the chief concern of a corporate treasurer who asks whether the firm can fund its liabilities.
- Market or asset liquidity risk is asset illiquidity or the inability to easily exit a position.
- The most popular and crudest measure of liquidity is the bid-ask spread—a low or narrow bid-ask spread is said to be tight and tends to reflect a more liquid market.
What Is Liquidity Risk?
Liquidity is a term used to refer to how easily an asset or security can be bought or sold in the market. It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.
Funding Liquidity Risk
Funding or cash flow liquidity risk is the chief concern of a corporate treasurer who asks whether the firm can fund its liabilities. A classic indicator of funding liquidity risk is the current ratio (current assets/current liabilities) or, for that matter, the quick ratio . A line of credit would be a classic mitigant.
Market Liquidity Risk
Market or asset liquidity risk is asset illiquidity . This is the inability to easily exit a position. For example, we may own real estate but, owing to bad market conditions, it can only be sold imminently at a fire sale price. The asset surely has value, but as buyers have temporarily evaporated, the value cannot be realized.
Consider its virtual opposite, a U.S. Treasury bond . True, a U.S. Treasury bond is considered almost risk-free as few imagine the U.S. government will default . But additionally, this bond has extremely low liquidity risk. Its owner can easily exit the position at the prevailing market price. Small positions in S&P 500 stocks are similarly liquid. They can be quickly exited at the market price. But positions in many other asset classes, especially in alternative assets , cannot be exited with ease. In fact, we might even define alternative assets as those with high liquidity risk.
Market liquidity risk can be a function of the following:
- The market microstructure. Exchanges such as commodity futures are typically deep markets , but many over-the-counter (OTC) markets are thin .
- Asset type. Simple assets are more liquid than complex assets. For example, in the crisis, CDOs -squared—CDO 2 are structured notes collateralized by CDO tranches—became especially illiquid due to their complexity.
- Substitution. If a position can be easily replaced with another instrument, the substitution costs are low and the liquidity tends to be higher.
- Time horizon. If the seller has urgency, this tends to exacerbate the liquidity risk. If a seller is patient, then liquidity risk is less of a threat.
Note the common feature of both types of liquidity risk: In a sense, they both involve the fact that there's not enough time. Illiquidity is generally a problem that can be solved with more time.
Measures of Market Liquidity Risk
There are at least three perspectives on market liquidity as per the above figure. The most popular and crudest measure is the bid-ask spread . This is also called width. A low or narrow bid-ask spread is said to be tight and tends to reflect a more liquid market .
Depth refers to the ability of the market to absorb the sale or exit of a position. An individual investor who sells shares of Apple, for example, is not likely to impact the share price . On the other hand, an institutional investor selling a large block of shares in a small capitalization company will probably cause the price to fall. Finally, resiliency refers to the market's ability to bounce back from temporarily incorrect prices.
- The bid-ask spread measures liquidity in the price dimension and is a feature of the market, not the seller or the seller's position. Financial models that incorporate the bid-ask spread adjust for exogenous liquidity and are exogenous liquidity models.
- Position size, relative to the market, is a feature of the seller. Models that use this measure liquidity in the quantity dimension and are generally known as endogenous liquidity models.
- Resiliency measures liquidity in the time dimensions and such models are currently rare.
At one extreme, high market liquidity would be characterized by the owner of a small position relative to a deep market that exits into a tight bid-ask spread and a highly resilient market.
A low or narrow bid-ask spread is said to be tight and tends to reflect a more liquid market.
What About Volume?
Trading volume is a popular measure of liquidity but is now considered to be a flawed indicator. High trading volume does not necessarily imply high liquidity. The Flash Crash of May 6, 2010, proved this with painful, concrete examples.
In that case, according to the Securities and Exchange Commission (SEC), sell algorithms were feeding orders into the system faster than they could be executed. Volume jumped, but many backlog orders were not filled. According to the SEC, "especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity."
Incorporating Liquidity Risk
In the case of exogenous liquidity risk, one approach is to use the bid-ask spread to directly adjust the metric. Please note: Risk models are different than valuation models and this method assumes there are observable bid/ask prices.
Let's illustrate with value-at-risk (VAR). Assume the daily volatility of a $1,000,000 position is 1.0%. The position has positive expected return , also referred to as drift, but as our horizon is daily, we bring our tiny daily expected return down to zero. This is a common practice. So let the expected daily return equal zero. If the returns are normally distributed, then the one-tailed deviate at 5.0% is 1.65. That is, the 5% left tail of normal distribution is 1.65 standard deviations to the left of mean. In excel, we get this result with =NORM.S.INV(5%) = -1.645.
The 95% value at risk (VAR) is given by:
$1,000,000 * 1.0% volatility * 1.65 = $16,500
Under these assumptions, we can say "only 1/20 days (5% of the time) do we expect the daily loss to exceed $16,500." But this does not adjust for liquidity.
Let's assume the position is in a single stock where the ask price is $20.40 and the bid price is $19.60, with a midpoint of $20. In percentage terms the spread (%) is:
($20.40 - $19.60) ÷ $20 = 4.0%
The full spread represents the cost of a round trip: Buying and selling the stock. But, as we are only interested in the liquidity cost if we need to exit (sell) the position, the liquidity adjustment consists of adding one-half (0.5) the spread. In the case of VaR, we have:
- Liquidity cost (LC) = 0.5 x spread
- Liquidity-adjusted VaR (LVaR) = position ($) * [-drift (%) + volatility *deviate + LC], or
- Liquidity-adjusted VaR (LVaR) = position ($) * [-drift (%) + volatility *deviate + 0.5 * spread].
In our example,
LVaR = $1,000,000 * [-0% + 1.0% * 1.65 + 0.5 * 4.0%] = $36,500
In this way, the liquidity adjustment increases the VaR by one-half the spread ($1,000,000 * 2% = +$20,000).
The Bottom Line
Liquidity risk can be parsed into funding (cash-flow) or market (asset) liquidity risk. Funding liquidity tends to manifest as credit risk , or the inability to fund liabilities produces defaults. Market liquidity risk manifests as market risk , or the inability to sell an asset drives its market price down, or worse, renders the market price indecipherable. Market liquidity risk is a problem created by the interaction of the seller and buyers in the marketplace. If the seller's position is large relative to the market, this is called endogenous liquidity risk (a feature of the seller). If the marketplace has withdrawn buyers, this is called exogenous liquidity risk—a characteristic of the market which is a collection of buyers—a typical indicator here is an abnormally wide bid-ask spread.
A common way to include market liquidity risk in a financial risk model (not necessarily a valuation model) is to adjust or "penalize" the measure by adding/subtracting one-half the bid-ask spread.
Federal Reserve Bank of San Francisco. " Liquidity Risk and Credit in the Financial Crisis ."
The Brookings Institution. " Market Liquidity: A Primer ."
U.S. Securities and Exchange Commission. " Findings Regarding the Market Events of May 6, 2010 ."
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- © 2016
Liquidity Risk, Efficiency and New Bank Business Models
- Santiago Carbó Valverde 0 ,
- Pedro Jesús Cuadros Solas 1 ,
- Francisco Rodríguez Fernández 2
Bangor Business School and FUNCAS , Bangor, United Kingdom
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University of Granada, Granada, Spain
This collection provides an overview of the latest research topics in the academic study of finance and banking to enrich our understanding of recent trends and research tendencies
Empirical studies offer a clear framework to illuminate the novel research that is being conducted in the post-financial crisis period
Contributors hail from a wide range of European countries and universities to offer a varied and holistic view of topics such as liquidity risk and efficiency, and new bank business models
The papers are the product of vibrant and extensive discussions at the Wolpertinger Conference, 2015
Part of the book series: Palgrave Macmillan Studies in Banking and Financial Institutions (SBFI)
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Table of contents (10 chapters)
Front matter, introduction.
- Santiago Carbó Valverde, Pedro J. Cuadros Solas, Francisco Rodríguez Fernández
A Note on Regulatory Arbitrage: Bank Risk, Capital Risk, Interest Rate Risk and ALM in European Banking
- Magnus Willesson
Basel III, Liquidity Risk and Regulatory Arbitrage
- Viktor Elliot, Ted Lindblom
OTC Derivatives and Counterparty Credit Risk Mitigation: The OIS Discounting Framework
- Paola Leone, Massimo Proietti, Pasqualina Porretta, Gianfranco A. Vento
Diversification and Connections in Banking: First Findings
- Claudio Zara, Luca Cerrato
Banking System and Financial Exclusion: Towards a More Comprehensive Approach
- Marta de la Cuesta González, Cristina Ruzay Paz-Curbera, Beatriz Fernández Olit
Small and Medium-Sized Banks in Central and Eastern European Countries
- Katarzyna Mikołajczyk
Stock Returns and Bank Ratings in the PIIGS
- Carlos Salvador Muñoz
Value Creation Drivers in European Banks: Does the Capital Structure Matter?
- Josanco Floreani, Maurizio Polato, Andrea Paltrinieri, Flavio Pichler
Liquidity Mismatch, Bank Borrowing Decision and Distress: Empirical Evidence from Italian Credit Co-Operative Banks
- Gianfranco Vento, Andrea Pezzotta, Stefano Di Colli
This book provides insight into current research topics in finance and banking in the aftermath of the financial crisis. In this volume, authors present empirical research on liquidity risk discussed in the context of Basel III and its implications. Chapters also investigate topics such as bank efficiency and new bank business models from a business diversification perspective, the effects on financial exclusion and how liquidity mismatches are related with the bank business model. This book will be of value to those with an interest in how Basel III has had a tangible impact upon banking processes, particularly with regard to maintaining liquidity, and the latest research in financial business models.
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Santiago Carbó Valverde
Pedro Jesús Cuadros Solas, Francisco Rodríguez Fernández
Santiago Carbó-Valverde is Professor of Economics and Finance at Bangor University, UK. He was previously a Professor of Economics at the University of Granada, Spain. He currently serves as Director of the Financial Services Studies of Spanish Savings Banks Association (FUNCAS) and as President of the Rating Committee of Axexor. He has been advisor to the European Central Bank, the Federal Reserve Bank of Chicago, financial institutions, such as BMN, and has spoken at the G-20 forum.
Pedro Jesús Cuadros-Solas is a Lecturer in Economics and a Researcher in Banking and Finance at the University of Granada, Spain. He holds a Bsc in Business Management and Law from the University of Jaén, Spain, and a Msc in Economics from the University of Granada. He is also a member of the Department of Economic Theory and History at the University of Granada. He has been a visiting scholar at the Bangor Business School (UK) and also at the University of St. Andrews, UK.
Francisco Rodríguez-Fernández is Professor of Economics at the University of Granada, Spain. He is also a Senior Economist at the Spanish Savings Banks Foundation (FUNCAS). He has spent time as a visiting scholar at the University of Modena (Italy), Bangor Business School (UK) and the Federal Reserve Bank of Chicago (USA). He has served as a consultant to the European Commission, the European Research Framework Programme, the Spanish Ministry of Labour, KPMG and Euro 6000.
Book Title : Liquidity Risk, Efficiency and New Bank Business Models
Editors : Santiago Carbó Valverde, Pedro Jesús Cuadros Solas, Francisco Rodríguez Fernández
Series Title : Palgrave Macmillan Studies in Banking and Financial Institutions
DOI : https://doi.org/10.1007/978-3-319-30819-7
Publisher : Palgrave Macmillan Cham
eBook Packages : Business and Management , Business and Management (R0)
Copyright Information : Springer International Publishing AG 2016
Hardcover ISBN : 978-3-319-30818-0 Published: 26 September 2016
Softcover ISBN : 978-3-319-80894-9 Published: 14 June 2018
eBook ISBN : 978-3-319-30819-7 Published: 10 September 2016
Series ISSN : 2523-336X
Series E-ISSN : 2523-3378
Edition Number : 1
Number of Pages : XXI, 305
Number of Illustrations : 9 b/w illustrations, 22 illustrations in colour
Topics : Business Finance , Investments and Securities , Financial Services
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What is Liquidity Risk?
In the ordinary course of business, firms enter into contractual obligations that may require future cash payments, including funding for customer loan requests, customer deposit maturities and withdrawals, debt service, leases for premises and equipment, and other cash commitments.
The objective of effective liquidity management is to ensure that firms can meet their contractual obligations and other cash commitments efficiently under both normal operating conditions and under periods of market stress. To help achieve this objective, Boards must establish liquidity guidelines that require sufficient asset-based liquidity to cover potential funding requirements, and to avoid over-dependence on volatile, less reliable funding markets.
According to the Basel Committee, during the early “liquidity phase” of the financial crisis that began in 2007, many banks – despite adequate capital levels – still experienced difficulties because they did not manage their liquidity in a prudent manner.
The crisis again drove home the importance of liquidity to the proper functioning of financial markets and the banking sector.
Prior to the crisis, asset markets were buoyant and funding was readily available at low cost.
The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time.
The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and, in some cases, individual institutions.
The difficulties experienced by some banks were due to lapses in basic principles of liquidity risk management. In response, as the foundation of its liquidity framework, the Committee in 2008 published Principles for Sound Liquidity Risk Management and Supervision (“Sound Principles”).
The Sound Principles provide detailed guidance on the risk management and supervision of funding liquidity risk and should help promote better risk management in this critical area, but only if there is full implementation by banks and supervisors. As such, the Committee will coordinate rigorous follow up by supervisors to ensure that banks adhere to these fundamental principles.
To complement these principles, the Committee has further strengthened its liquidity framework by developing two minimum standards for funding liquidity. These standards have been developed to achieve two separate but complementary objectives.
The first objective is to promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive a significant stress scenario lasting for one month. The Committee developed the Liquidity Coverage Ratio (LCR) to achieve this objective.
The second objective is to promote resilience over a longer time horizon by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis. The Net Stable Funding Ratio (NSFR) has a time horizon of one year and has been developed to provide a sustainable maturity structure of assets and liabilities.
These two standards are comprised mainly of specific parameters which are internationally “harmonised” with prescribed values. Certain parameters, however, contain elements of national discretion to reflect jurisdiction-specific conditions. In these cases, the parameters should be transparent and clearly outlined in the regulations of each jurisdiction to provide clarity both within the jurisdiction and internationally.
It should be stressed that the standards establish minimum levels of liquidity for internationally active banks. Banks are expected to meet these standards as well as adhere to the Sound Principles. Consistent with the Committee’s capital adequacy standards, national authorities are free to require higher minimum levels of liquidity.
Learning from the Annual Reports
Liquidity Risk, important parts from the 2021 Annual Report, Scotiabank
Liquidity risk is the risk that the Bank is unable to meet its financial obligations in a timely manner at reasonable prices. Financial obligations include liabilities to depositors, payments due under derivative contracts, settlement of securities borrowing and repurchase transactions, and lending and investment commitments.
Effective liquidity risk management is essential to maintain the confidence of depositors and counterparties, manage the Bank’s cost of funds and to support core business activities, even under adverse circumstances.
Liquidity risk is managed within the framework of policies and limits that are approved by the Board of Directors. The Board receives reports on risk exposures and performance against approved limits. The Asset-Liability Committee (ALCO) provides senior management oversight of liquidity risk.
The key elements of the liquidity risk framework are:
• Measurement and modeling – the Bank’s liquidity model measures and forecasts cash inflows and outflows, including off-balance sheet cash flows on a daily basis. Risk is managed by a set of key limits over the maximum net cash outflow by currency over specified short-term horizons (cash gaps), a minimum level of core liquidity, and liquidity stress tests.
• Reporting – Global Risk Management provides independent oversight of all significant liquidity risks, supporting the ALCO with analysis, risk measurement, stress testing, monitoring and reporting.
• Stress testing – the Bank performs liquidity stress testing on a regular basis, to evaluate the effect of both industry-wide and Bank-specific disruptions on the Bank’s liquidity position. Liquidity stress testing has many purposes including:
– Helping the Bank understand the potential behavior of various on-balance sheet and off-balance sheet positions in circumstances of stress; and
– Based on this knowledge, facilitating the development of risk mitigation and contingency plans. The Bank’s liquidity stress tests consider the effect of changes in funding assumptions, depositor behavior and the market value of liquid assets. The Bank performs industry standard stress tests, the results of which are reviewed at senior levels of the organization and are considered in making liquidity management decisions.
• Contingency planning – the Bank maintains a liquidity contingency plan that specifies an approach for analyzing and responding to actual and potential liquidity events. The plan outlines an appropriate governance structure for the management and monitoring of liquidity events, processes for effective internal and external communication, and identifies potential counter measures to be considered at various stages of an event. A contingency plan is maintained both at the parent-level as well as for major subsidiaries.
• Funding diversification – the Bank actively manages the diversification of its deposit liabilities by source, type of depositor, instrument, term and geography.
• Core liquidity – the Bank maintains a pool of highly liquid, unencumbered assets that can be readily sold or pledged to secure borrowings under stressed market conditions or due to Bank-specific events. The Bank also maintains liquid assets to support its intra-day settlement obligations in payment, depository and clearing systems.
Liquid assets are a key component of liquidity management and the Bank holds these types of assets in sufficient quantity to meet potential needs for liquidity management.
Liquid assets can be used to generate cash either through sale, repurchase transactions or other transactions where these assets can be used as collateral to generate cash, or by allowing the asset to mature.
Liquid assets include deposits at central banks, deposits with financial institutions, call and other short-term loans, marketable securities, precious metals and securities received as collateral from securities financing and derivative transactions. Liquid assets do not include borrowing capacity from central bank facilities.
Marketable securities are securities traded in active markets, which can be converted to cash within a timeframe that is in accordance with the Bank’s liquidity management framework. Assets are assessed considering a number of factors, including the expected time it would take to convert them to cash.
Marketable securities included in liquid assets are comprised of securities specifically held as a liquidity buffer or for asset liability management purposes; trading securities, which are primarily held by Global Banking and Markets; and collateral received for securities financing and derivative transactions.
Liquidity Risk, important parts from the 2021 Annual Report, Lloyds Banking Group plc
Liquidity risk is defined as the risk that the Group has insufficient financial resources to meet its commitments as they fall due, or can only secure them at excessive cost.
Liquidity risk is managed through a series of measures, tests and reports that are primarily based on contractual maturity.
The Group carries out monthly stress testing of its liquidity position against a range of scenarios. The Group’s liquidity risk appetite is also calibrated against a number of stressed liquidity metrics.
FUNDING AND LIQUIDITY RISK
Funding risk is defined as the risk that the Group does not have sufficiently stable and diverse sources of funding or the funding structure is inefficient. Liquidity risk is defined as the risk that the Group has insufficient financial resources to meet its commitments as they fall due, or can only secure them at excessive cost.
Liquidity exposure represents the potential stressed outflows in any future period less expected inflows. The Group considers liquidity exposure from both an internal and a regulatory perspective.
Liquidity risk is managed through a series of measures, tests and reports that are primarily based on contractual maturities with behavioural overlays as appropriate. Note 51 on page F-121 sets out an analysis of assets and liabilities by relevant maturity grouping. The Group undertakes quantitative and qualitative analysis of the behavioural aspects of its assets and liabilities in order to reflect their expected behaviour.
The Group manages and monitors liquidity risks and ensures that liquidity risk management systems and arrangements are adequate with regard to the internal risk appetite, Group strategy and regulatory requirements. Liquidity policies and procedures are subject to independent internal oversight by Risk. Overseas branches and subsidiaries of the Group may also be required to meet the liquidity requirements of the entity’s domestic country.
Management of liquidity requirements is performed by the overseas branch or subsidiary in line with Group policy. Liquidity risk of the Insurance business is actively managed and monitored within the Insurance business. The Group plans funding requirements over its planning period, combining business as usual and stressed conditions.
The Group manages its liquidity position both with regard to its internal risk appetite and the Liquidity Coverage Ratio (LCR) as required by the PRA, the Capital Requirements Directive (CRD IV) and the Capital Requirements Regulation (CRR) liquidity requirements. The Group’s funding and liquidity position is underpinned by its significant customer deposit base, and is supported by strong relationships across customer segments.
The Group has consistently observed that in aggregate the retail deposit base provides a stable source of funding. Funding concentration by counterparty, currency and tenor is monitored on an ongoing basis and where concentrations do exist, these are managed as part of the planning process and limited by the internal funding and liquidity risk monitoring framework, with analysis regularly provided to senior management.
To assist in managing the balance sheet, the Group operates a Liquidity Transfer Pricing (LTP) process which: allocates relevant interest expenses from the centre to the Group’s banking businesses within the internal management accounts; helps drive the correct inputs to customer pricing; and is consistent with regulatory requirements. LTP makes extensive use of behavioural maturity profiles, taking account of expected customer loan prepayments and stability of customer deposits, modelled on historic data.
The Group can monetise liquid assets quickly, either through the repurchase agreements (repo) market or through outright sale. In addition, the Group has pre-positioned a substantial amount of assets at the Bank of England’s Discount Window Facility which can be used to access additional liquidity in a time of stress. The Group considers diversification across geography, currency, markets and tenor when assessing appropriate holdings of liquid assets. The Group’s liquid asset buffer is available for deployment at immediate notice, subject to complying with regulatory requirements.
Liquidity risk within the Insurance business may result from: the inability to sell financial assets quickly at their fair values; an insurance liability falling due for payment earlier than expected; the inability to generate cash inflows as anticipated; an unexpected large operational event; or from a general insurance catastrophe, for example, a significant weather event. Liquidity risk is actively managed and monitored within the Insurance business to ensure that it remains within approved risk appetite, so that even under stress conditions, there is sufficient liquidity to meet obligations.
Daily monitoring and control processes are in place to address internal and regulatory liquidity requirements. The Group monitors a range of market and internal early warning indicators on a daily basis for early signs of liquidity risk in the market or specific to the Group.
This captures regulatory metrics as well as metrics the Group considers relevant for its liquidity profile. These are a mixture of quantitative and qualitative measures, including: daily variation of customer balances; changes in maturity profiles; funding concentrations; changes in LCR outflows; credit default swap (CDS) spreads; and basis risks.
The Group carries out internal stress testing of its liquidity and potential cash flow mismatch position over both short (up to one month) and longer-term horizons against a range of scenarios forming an important part of the internal risk appetite. The scenarios and assumptions are reviewed at least annually to ensure that they continue to be relevant to the nature of the business, including reflecting emerging horizon risks to the Group.
The Group maintains a Contingency Funding Framework as part of the wider Recovery Plan which is designed to identify emerging liquidity concerns at an early stage, so that mitigating actions can be taken to avoid a more serious crisis developing. Contingency Funding Plan invocation and escalation processes are based on analysis of five major quantitative and qualitative components, comprising assessment of: early warning indicators; prudential and regulatory liquidity risk limits and triggers; stress testing results; event and systemic indicators; and market intelligence.
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The Role of the Risk Officer: https://www.risk-officer.com/Role_Of_Risk_Officer.html
Credit Risk: https://www.risk-officer.com/Credit_Risk.htm
Market Risk: https://www.risk-officer.com/Market_Risk.htm
Operational Risk: https://www.risk-officer.com/Operational_Risk.htm
Systemic Risk: https://www.risk-officer.com/Systemic_Risk.htm
Political Risk: https://www.risk-officer.com/Political_Risk.htm
Strategic Risk: https://www.risk-officer.com/Strategic_Risk.htm
Conduct Risk: https://www.risk-officer.com/Conduct_Risk.htm
Reputation Risk: https://www.risk-officer.com/Reputation_Risk.htm
Liquidity Risk: https://www.risk-officer.com/Liquidity_Risk.htm
Cyber Risk: https://www.risk-officer.com/Cyber_Risk.htm
Climate Risk: https://www.risk-officer.com/Climate_Risk.htm
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How do I calculate the liquidity risk of a company?
What is liquidity risk?
Liquidity risk in economics is the capability of a company to meet its short-term debts , based on its current liquid assets.
Liquidity is the capability of an asset to be transformed immediately into cash without producing a loss in its value. Current assets are liquid assets that can be converted into cash within 12 months, such as cash on hand and in banks, customer debts, short-term financial investments.
A couple of examples to understand the concept
An example of liquidity risk would be when a company has assets in excess of its debts but cannot easily convert those assets to cash and cannot pay its debts because it does not have sufficient current assets.
Another example would be when an asset is illiquid and must be sold at a price below the market price. This liquidity risk usually affects assets that are not traded frequently, such as real estate or bonds. If we were to urgently sell an illiquid asset, we would lose profits by having to lower its price in order to sell it.
How do we measure liquidity risk?
- Indicates a company’s ability to meet upcoming debt payments with the most liquid part of its assets (cash on hand and short-term investments).
- It is the ratio between current assets (liquid resources of the company) and current liabilities (short-term debts).
- An optimal liquidity ratio is between 1.5 and 2.
- This formula does not take into account inventories because of their low capacity to be converted into cash in the short term.
- It is calculated by dividing current assets less inventory by current liabilities.
- The optimum ratio is 1, above this figure there is good capacity to meet payments, below 1 there are weaknesses.
- It is obtained by dividing cash on hand plus financial assets (cash and cash equivalents) by current liabilities.
- The optimum ratio is 1.
How can we manage liquidity risk?
The liquidity policy should be designed according to the specific characteristics of each company, establishing a contingency plan for possible crises.
Broadly speaking, we could highlight the following practices to reduce liquidity risk:
- Maintain sufficient cash on hand.
- Be able to access loans and diversify funding sources.
- Ability to convert liquid assets into cash quickly.
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What it is and why it matters.
Liquidity is a bank's ability to meet its cash and collateral obligations without sustaining unacceptable losses. Liquidity risk refers to how a bank’s inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM).
During the recent prolonged period of historically low and stable interest rates, financial institutions of all shapes and sizes took liquidity and balance sheet management for granted. But as rates rose and uncertainty increased, many institutions struggled to maintain adequate liquidity and appropriate balance sheet structure due to deposit run-offs and portfolio duration mismatches.
Liquidity risk was exacerbated by asset value deterioration while monetary policy tightened. Inadequate balance sheet management led to highly publicized bank failures and a heightened awareness of liquidity risks.
In the wake of these bank failures, one thing became clear: banks and capital markets firms need to manage their liquidity and balance sheets better. And self-preservation isn’t the only motive for doing so. The consequences of poor asset liability management and liquidity risk management can reach far beyond the walls of any one financial institution. It can create a contagion effect on the entire financial ecosystem and even the global economy.
Regulatory bodies are intent on preventing another financial crisis in the future, and scrutiny of liquidity management is increasing. The onus is now on financial institutions to shore up liquidity risk and balance sheet management – for the good of the firm and the economy.
Liquidity risk management defined
Liquidity risk management and ALM encompass the processes and strategies a bank uses to:
- Ensure a balance sheet earns a desired net interest margin without exposing the institution to undue risks from interest rate volatility, credit risk, prepayment dynamics and deposit run-off.
- Plan and structure a balance sheet with a proper mix of assets and liabilities to optimize the risk/return profile of the institution going forward.
- Assess its ability to meet cash flow and collateral needs (under normal and stressed conditions) without negatively affecting day-to-day operations, overall financial position or public sentiment.
- Mitigate risk by developing strategies and taking appropriate actions to ensure that necessary funds and collateral are available when needed.
The role of balance sheet management
Balance sheet management, through strategic ALM, is the process of managing and optimizing assets, liabilities and cash flows to meet current and future obligations. Effective ALM not only protects financial institutions against the risks of falling net interest margins and funding crunches – it's also an opportunity to enhance value by optimizing reward versus risk.
Good asset liability management broadly covers portfolio accounting, analytics and optimization. It relies on a suite of tools for transaction capture, forecasting, interest rate risk measurement, stress testing, liquidity modeling and behavioral analytics.
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Challenges to successful balance sheet management
- No centralized view of balance sheet management. Siloed departments and business units limit a firm’s ability to understand its balance sheet positions (especially those involving optionality and customer behavior). Silos also make it challenging to assess the impact of illiquid assets across geographies, business units and asset classes.
- Limited analytics capabilities. Without sufficient analytics, firms have extreme difficulty projecting cash flows and net interest margins for underlying transactions, particularly when those transactions number in the millions. Overly simplified term structure and behavioral models lead to limited balance sheet risk management.
- Insufficient stress testing. Because too many firms have commonly ignored trading and funding liquidity considerations in stress testing, they are unprepared for the impacts of market shocks, making it hard for them to get out of positions easily or to attract new funding.
- Overcoming the compliance mindset. Firms that focus too much on the compliance requirements surrounding balance sheet management may overlook potential business benefits.
3 steps to successful liquidity risk management and ALM
To institute an effective liquidity risk management and ALM system at your organization, follow these three steps.
1. Establish an analytic framework for calculating risk, optimizing capital and measuring market events and liquidity.
- Minimize the effects of market shocks and look for better risk management opportunities by analyzing the consequences of changes in cost and liquidity in near-real time. Then you can act with precision.
- Analyze cash flow and market value dynamics comprehensively and granularly. Proactively manage your assets and liabilities with on-demand scenario analysis incorporating forward-looking market condition and balance sheet evolution assumptions.
2. Manage your data.
- Gain a centralized view of firmwide interest rate and liquidity risks by integrating the latest market information, portfolio updates, capital returns and a market view of liquidity on an intraday scenario basis.
3. Integrate your risk management processes.
- Value complex portfolios and asset classes using an efficient platform to integrate portfolio valuation and scenario analyses with consistent market, credit and behavioral models. Process orchestration and governance can further reduce operational risk.
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