Measuring and Managing Liquidity Risk

4

The new framework

4.1 INTRODUCTION

The financial crisis which started in mid-2007 took financial institutions and supervisors by surprise because it followed a long period of time characterized by ample liquidity, compressed spreads and low volatility. The wave of deregulation, coupled by increasing globalization and the development of increasingly complex derivatives products, led to risk-prone behaviours and weakened the resilience of the financial system to the shock that originated in the core business of the banking system, the asset–liability maturities' mismatch.

Since the most relevant shocks to financial markets over the previous years had been produced by excessive exposures to market factors or counterparty risk, the Basel II framework aimed at addressing mainly these issues rather than focusing on liquidity risk. As a consequence, this kind of risk was widely downplayed or ignored by academics and practitioners, while the backdrop of financial innovation quickly made both current banks' liquidity risk management practices and supervisory standards irrelevant.

The impact on global liquidity recorded during the crisis was largely affected by two main trends: increased recourse by capital markets to funding and augmented reliance on short-term maturity funding instruments. They were reinforced by the concurrent buildup of many forms of contingent liquidity claims (e.g., those linked to off-balance-sheet vehicles) and increasingly frequent margin requirements that were ...