A Risk Professional's Survival Guide: Applied Best Practices in Risk Management

CHAPTER 11 Liquidity Risk Management

A major contributing factor to the global financial crisis of 2008–2009 was a massive liquidity crisis that transpired in 2007–2008 and a liquidity bubble that grew during the years leading up to 2007. Two important events during this period helped shape what would eventually become one of the worst financial catastrophes in history. In the United States, the housing market had undergone an enormous transformation, expanding into a variety of new and more exotic mortgage products that helped fuel extraordinary demand for mortgages. During this time, banks increasingly moved away from putting these mortgages into their own portfolios to packaging them up for sale as mortgage-backed securities, or MBS. To fund this highly profitable mortgage securitization activity, firms increasingly relied upon shorter-term financing instruments and over time turned their attention to nonbank funding sources via the shadow banking system such as asset-backed commercial paper (ABCP) and term repos. Funding with ABCP instruments having maturities of one year or shorter and collateralized by mortgages permitted banks to enhance their profitability by boosting the spread between the income earned on longer-term assets and expense on shorter-term liabilities. Banks could face liquidity risk if their access to ABCP was cut off, thus preventing them from rolling over their debt. Hence, lines of credit extended to banks, called liquidity backstops, were common during ...