Asset-Liability and Liquidity Management

CHAPTER 11Liquidity Risk

In previous chapters we discussed how a bank manages its sources and uses of funds by analyzing the impact of raised funds (liabilities) and used funds (assets) on its net interest income and the economic value of equity. An imbalance between incomes earned and expenses paid, or a mismatch between economic values of assets and liabilities, can expose the bank to market risk. Another aspect of efficient bank management is with regard to the timing of when principal or interest of funds borrowed are due and funds lent are returned. A mismatch in the timing of these cash flows can expose the bank to liquidity risk. Liquidity risk is the risk arising from a firm's inability to meet its obligations when they come due without incurring excessive losses or unacceptable costs.

Prior to 2007, financial companies generally treated liquidity risk management as an isolated task and often part of their cash management activities. Traditionally, teams that oversaw a firm's assets had freedom to market and sell their products or make relevant investments, with some restrictions, but often regardless of the impact of their activities on overall liquidity of the firm. This was not causing issues particularly for banks and investment banks during the 1990s and early 2000s due to ease of raising funds. In that period, innovation such as securitization and short-term borrowing through repurchase agreement (repo) contracts made it easy for many financial firms to borrow, ...