Liquidity risk is an important source of financial risk, as we have witnessed in the latest credit crisis. The crisis of confidence that started with subprime losses suddenly accelerated after the Lehman bankruptcy. Many debt holders refused to roll over their investments, creating massive funding problems for financial institutions. These problems were compounded by their difficulties in selling assets to meet funding needs.
Liquidity risk, unfortunately, is less amenable to formal risk measurement, unlike market risk, credit risk, and operational risk. This is why the Basel Committee on Banking Supervision (BCBS) did not institute formal capital charges against liquidity risk. Yet, it stated: “Liquidity is crucial to the ongoing viability of any banking organization. Banks' capital positions can have an effect on their ability to obtain liquidity, especially in a crisis.”1 Thus it is crucial for financial institutions to assess, monitor, and manage their liquidity risk.
Section 26.1 describes sources of liquidity risk, which involve both asset liquidity risk and funding risk. Section 26.2 analyzes asset liquidity risk. The ability to liquidate assets to generate cash depends on market conditions, including bid-ask spreads and market impact, as well as the liquidation time horizon. To some extent, value at risk (VAR) can be expanded into a liquidity-adjusted VAR. Section 26.3 then analyzes funding liquidity risk. This is illustrated using the example ...