Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

12.3 Funding Liquidity Risk

We now turn from a focus on the asset side of the balance sheet to look at the liability side. Quantitative risk measurement is mostly concerned with statistics, probability, and mathematics. But as I have tried to emphasize throughout this book, risk management is about managing the firm, doing whatever it takes, using whatever tools and techniques are available and necessary, to understand and manage the risk. Funding liquidity risk is a prime case of when we do not necessarily need fancy mathematics; we need instead common sense and attention to details.

Funding liquidity focuses on the sources of funds. Risk management and risk measurement generally focus on the uses of funds, the investments, and assets held. Funding and the liability side of the balance sheet are not the natural province of most risk professionals. Funding more naturally falls under the CFO or Treasury function rather than trading. Having said that, funding liquidity is critically important. During a crisis, it is often the liquidity issues that bring down a firm. To mention only a few instances, LTCM, Metallgesellschaft, and Askin Capital Management were all subject to severe liquidity issues. Such problems become paramount and industry-wide during a liquidity crisis such as the U.S. subprime-triggered crisis of 2007–2009 and the eurozone crisis that began in 2011.

What is funding liquidity risk? Simply stated, it arises from mismatches between assets and liabilities. Not mismatches ...