Liquidity Risk

Liquidity risk is the risk that a firm cannot meet its payment obligations when they fall due, or can meet them only by raising cash at an unacceptable cost. Every business faces it, but banks are especially exposed because they fund long-term loans with deposits that customers can withdraw at short notice. Supervisors, treasurers and investors treat it as one of the main financial risks, alongside credit risk, market risk and operational risk.

Two forms are usually distinguished. Funding liquidity risk is the risk of running out of cash or borrowing capacity; market liquidity risk is the risk that an asset cannot be sold quickly without a steep discount. They feed each other in a crisis. Liquidity risk also differs from insolvency: a bank can have more assets than debts on paper and still fail because it cannot pay today.

Picture a family that owns a valuable house but has little money in its current account. If a large bill arrives tomorrow, the house does not help much. Selling it takes months, and a rushed sale means accepting far less than it is worth. The family is wealthy, yet it can still miss the payment.

Banks face the same squeeze on a larger scale. Most of their wealth sits in loans and bonds that pay back slowly, while depositors can ask for their money at any moment. In normal times only a few do, and the bank copes easily. If many ask at once, the bank must find cash fast, borrow at high rates or sell assets cheaply. Liquidity risk is the chance that it cannot do so in time.

Funding liquidity risk comes from mismatches in timing. Maturity transformation, turning short-term deposits into long-term loans, is the core of banking, but it means outflows can outrun the cash a bank has to hand. Sources of strain include deposit withdrawals, wholesale lenders refusing to roll over funding, drawdowns of committed credit lines and margin calls on derivatives. In payment systems, the same risk appears within the day, when a bank's outgoing payments run ahead of incoming ones and it must rely on intraday credit.

Market liquidity risk concerns the assets a firm hopes to sell or pledge. In calm markets, government bonds can be sold in size at close to their quoted price. In stress, buyers step back, bid-ask spreads widen and lenders apply larger haircuts to collateral. A firm forced to sell into such a market pushes prices down further, a fire sale that can spread losses to other holders. The broader concept of liquidity covers both how easily assets trade and how readily cash can be raised.

Liquidity problems tend to build slowly and break suddenly. In September 2007 the British lender Northern Rock, which relied heavily on wholesale funding, lost access to markets and needed emergency support from the Bank of England; news of the support triggered queues of depositors outside its branches. During the 2008 financial crisis, frozen interbank and repo markets turned funding strains into failures at much larger institutions.

The speed of a modern bank run was shown in March 2023, when depositors withdrew about 42 billion dollars from Silicon Valley Bank in a single day, 9 March, and regulators closed the bank the next morning. Central banks act as lender of last resort to solvent banks facing a liquidity crisis, and deposit insurance reduces the incentive for insured depositors to run.

After 2008, the Basel Committee on Banking Supervision added two liquidity standards to Basel III. The first, the liquidity coverage ratio (LCR), finalised in January 2013, tests whether a bank could survive a 30-day stress scenario. It is calculated as:

• $\text{HQLA}$ is the stock of high-quality liquid assets, such as central bank reserves and government bonds, after haircuts.
• $\text{Outflows}$ are expected cash outflows over the next 30 calendar days under the regulatory stress assumptions.
• $\text{Inflows}$ are expected inflows over the same period, capped at 75% of outflows so a bank cannot rely on them entirely.

Worked example: a bank holds 150 billion in HQLA, expects 160 billion of stressed outflows and 50 billion of inflows. The inflow cap is $0.75 \times 160 = 120$, so all 50 billion counts. Net outflows are $160 - 50 = 110$, and the LCR is $\frac{150}{110} \times 100\% \approx 136\%$. The minimum is 100%, phased in from 60% in 2015 to the full level in January 2019.

The second standard, the net stable funding ratio (NSFR), published in October 2014 and applied from January 2018, looks a year ahead: available stable funding must be at least 100% of required stable funding, which discourages funding long-term assets with short-term money. In the United States, regulators adopted the LCR in 2014 and the NSFR with effect from July 2021, applying them mainly to the largest banks.

Within banks, liquidity management sits with the treasury and an asset-liability committee. Common practices include:

• Liquidity buffers. Banks hold reserves and short-term government securities such as treasury bills that can be sold or pledged at once.
• Diversified funding. Spreading funding across depositors, maturities and markets reduces the chance of all sources drying up together.
• Stress testing and contingency plans. Banks model severe scenarios and keep a contingency funding plan, including collateral pre-positioned at the central bank.

• Basel Committee on Banking Supervision: Basel III, The Liquidity Coverage Ratio and liquidity risk monitoring tools
• Basel Committee on Banking Supervision: Basel III, The Net Stable Funding Ratio