CHAPTER 21

Liquidity Risk

The credit crisis that started in the middle of 2007 has emphasized the importance of liquidity risk for both financial institutions and their regulators. Many financial institutions that relied on wholesale deposits for their funding experienced problems as investors lost confidence in financial institutions. Moreover, financial institutions found that many instruments for which there had previously been a liquid market could only be sold at fire-sale prices during the crisis.

It is important to distinguish solvency from liquidity. Solvency refers to a company having more assets than liabilities, so that the value of its equity is positive. Liquidity refers to the ability of a company to make cash payments as they become due. Financial institutions that are solvent can—and sometimes do—fail because of liquidity problems. Consider a bank whose assets are mostly illiquid mortgages. Suppose the assets are financed 90% with deposits and 10% with equity. The bank is comfortably solvent. But it could fail if there is a run on deposits with 25% of depositors suddenly deciding to withdraw their funds. In this chapter we will examine how Northern Rock, a British bank specializing in mortgage lending, failed largely because of liquidity problems of this type.

It is clearly important for financial institutions to manage liquidity carefully. Liquidity needs are uncertain. Financial institutions must assess a worst-case liquidity scenario and make sure that they ...

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