Funding and liquidity risk is defined by the Bank for International Settlements (BIS, 2008) as “…the risk that the firm will not be able to meet efficiently both expected and unexpected current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the firm.”
This risk has little to do with being economically insolvent but can be just as deadly. The distinction is important: it has been argued that some economically solvent firms were forced into resolution due to a liquidity crisis during the 2008 financial crisis (see the case examples later in this chapter) while other, insolvent firms – the “walking dead” or “zombies” – continued to function only because government liquidity support prevented their collapse.1
In contrast to other risks, managing liquidity risk is not about holding more capital: if customers do not believe that the bank or insurer can cover its obligations, then they will seek to recover their deposits and redeem their policies, representing a draw on the firm's liquidity and creating a self-fulfilling, downward spiral. Additional capital will not help once the spiral is initiated; liquidity risk management is about avoiding the spiral in the first place.
High-level principles for managing funding liquidity risk can be found for the banking industry in BIS (2008) and for the insurance industry in CRO Forum (2008). Summarizing ...