Published in partnership with Quantifi, a provider of risk, analytics and trading solutions
Historically, liquidity risk has been the poor cousin of market risk and credit risk. While the global financial crisis of 2008/2009 first pushed the issue of liquidity risk to the forefront of attention, the most recent market dislocation due to the Covid-19 pandemic has once again highlighted the salient significance of the topic.
This is particularly so for institutional investment managers who have to meet margin calls, perform regular fund rebalancing, and execute redemptions, among other potentially liquidity-threatening activities. Failure to afford liquidity risk management the focus and priority jeopardizes the health of an institution, perhaps fatally so.
Liquidity risk occurs when a financial institution is unable to meet its short-term debt obligations. It is a particular worry during periods of market stress when appetite to own certain assets evaporates, bid/offer spreads widen significantly, and an institution is either unable to liquidate those assets or can only do so at a crippling loss (see Figure 1).
Pension funds and other institutional asset managers tend to look at their liquidity risk in two different ways: through the prism of market liquidity and through the prism of funding liquidity. From a perspective of market liquidity, asset managers need to monitor their available liquidity in the future, particularly in the near-term. This also involves keeping track of the minimum liquidity requirement, the risk appetite, and also, for example, how to model possible haircuts when monetizing an asset.
Funding liquidity, in contrast, involves the capacity to project all possible cash flows and cash balances, as well as identifying potential funding gaps. Both of these functions are highly germane to the effective functioning of any financial institution, but basic financial exigencies are supplemented by regulatory and supervisory mandates to provide proper liquidity risk management.
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