An Introduction to Liquidity Risk

The essay presents liquidity risk in both its meanings, that is, funding risk and market liquidity risk. The former is the risk that a financial institution may not be able to face expected and unexpected cash outflows without jeopardising its orderly operations; the latter is the risk that the quick liquidation of a large amount of assets ends up affecting the price in a considerable (and unfavourable) manner, because of the limited depth (or momentary disruption) of the market where those assets are traded. As shown in the essay, funding risk is usually measured through liquidity gaps and ratios, and managed through contingency funding plans that ensure that the bank has access to enough funds in the event of a liquidity shortage; although simple in principle, the management of funding risk is made complex by the presence of assets and liabilities with a de facto maturity that is different from their contractual duration; such items (“non-maturing assets and liabilities”) are carefully dealt with in the chapter. Market liquidity risk requires that market risk VaR be adjusted to account for adverse price reactions and/or that the market VaR time horizon be extended, to allow for a gradual liquidation of the tradable portfolio; several formulae for this adjustment are proposed.