And on this cold winter day, some thoughts on Liquidity Risk, a matter of increasing interest in the market. Or so they tell me. Probably so at least till the current round of batten-the-hatches is in history.

The truth of the matter is that Liquidity Risk remains the least developed of the Risk Management disciplines…and I don’t really care for the debate on whether Liquidity is more important than profitability or the other way around.

• We rarely talk about Liquidity Risk except in crisis situations (and the immediate aftermath) by when of course it is too late
• There is little or no common language or dimensions around Liquidity, both of the Funding type and of the Trading/Transactional type
• Liquidity projections and exercises typically continue to focus on ‘contractual maturities’ of assets and liabilities instead of adding or superimposing views based on ‘behavioral-maturities’ and ‘stress-maturities’
• Models continue to assume that the markets fully absorb all required trades with unchanged small spreads, whereas we know for fact that at the margin there is limiting absorption of trades and that spreads can widen significantly, and that in crisis situations the absence of liquidity may go well beyond just a spread-widening issue to a complete lack of liquidity i.e. Liquidity can be binary – either there, or not at all

The perception of Liquidity, as we know, is as important as the reality of liquidity. And systemic risk is significantly about liquidity. And I argue that Liquidity Risk may well be the silo-breaker between different risk types – is it not true that when Liquidity disappears, Credit Risk and Market Risk are the same thing?

I like stress-testing exercises that include strong considerations of Liquidity crisis, whether at the level of the specific institution or the market as a whole. I like considerations of cumulative outflows, and varying defeasance assumptions (holding periods) and I like the LVAR focus on widening spreads. What I am still missing is a holistic approach to Liquidity Risk in the risk community, clear language and dimensions and metrics, explicit recognition of the role of committed liquidity facilities, and of course regulatory recognition of Liquidity in the context of systemic risk and leverage and capital adequacy

Thoughts?

Posted by Jaidev Iyer, MD, GARP at 3:43 PM