Measuring and Managing Liquidity Risk

2

A journey into liquidity

2.1 INTRODUCTION

In the previous chapter we stressed how the recent financial crisis was exacerbated by an increased funding liquidity risk that contaminated market liquidity for many structured products. In order to understand how liquidity risk can impact financial stability, we have to look closer at the various types of liquidity and deeply analyse the concept of liquidity itself, still vague and elusive in the literature.

The concept of risk is related to the probability distribution of the underlying random variable, with economic agents having well-defined preferences over the realizations of the random variable of interest. As economic agents would have a preference over liquidity, the probability of not being liquid would suggest the existence of liquidity risk.

To begin with, we need a coherent framework that properly defines and differentiates the financial liquidity types, and describes the transmission channels and spillover directions among them. For each liquidity type the respective liquidity risk will be defined.

We will refer to the work of Nikolaou [96], which provided a unified and consistent approach to financial liquidity and liquidity risk. She moved from the academic literature that treated the different concepts of liquidity in a rather fragmented way (central bank liquidity in the context of monetary policy, market liquidity in asset-pricing models, funding liquidity in the cash management framework) by concentrating, condensing ...