The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises

Chapter 2. Liquidity Risk: Concepts

2.1 Introduction

Before we talk about financial institutions and the global economic system, we need to define the key concepts surrounding liquidity. In this chapter, we first define liquidity and the cost of liquidity, as well as introduce the concepts of liquidity risk and liquidity risk premium in the financial markets. We then explain how financial institutions ranging from banks and insurance companies to pension funds and hedge funds bear considerable liquidity risk in their balance sheets and why they choose to do so. Finally, we discuss the effects that bearing illiquidity risk has on financial institutions, especially banks, and the subsequent effects these have on the global economy.

2.2 What Is ...