Chapter 6Liquidity Risk Management with Cash Flow Models

Classical asset and liability management focuses on a balance sheet view of the firm and the control of two key balance sheet risks: interest rate risk and liquidity risk. Banking book interest rate risk impact on profit and loss is often measured through the net interest margin of assets and liabilities. The net interest margin impact of interest rate changes is a cash flow view on the asset and liabilities interest flows. However, one can also assess the impact of the present value of all cash flows. This is a long-term solvency view referred to as an economic value view of the balance sheet.

The analysis of net interest margin and economic value of balance sheet is focused on short- and long-term profitability of the balance sheet. Profitability of a balance sheet is of course also connected to liquidity. However, profitability is no guarantee for liquidity. A financial institution that is long-term solvent (economic value view) can be short-term illiquid. We can define liquidity risk management broadly as the management of the bank's ability to meet its obligations as they come due, without incurring losses. In contrast to risk-based capital for other forms of risks, such as market and credit risk, the cushion for liquidity risk is not created through additional capital. This is because the hedge for liquidity risk is ultimately cash to offset the negative flows and restore liquidity.

Traditionally, liquidity risk ...

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