The Impact of Liquidity on Credit Risk, Market Risk, and Regulation

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.  Banks’ capital positions can influence 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 the 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 lifeblood 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 (or 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, e.g., the U.S. Treasury market. Conversely, a market that has low liquidity will have a wider bid/ask spread, e.g., the junk bond market. The U.S. 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 fungibility

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 to react, thus a pre-established plan is useful.

Joseph Iraci is Chair of the Operational Risk Council at RMA.