Journal of Money, Investment and Banking - Issue 10 (2009)
The nature of banking business implies that banks structurally invest in assets having a differentdegree of liquidity. Therefore, the liquidity of a financial firm involves several different managerialaspects. While a significant percentage of assets are illiquid and cannot be easily converted in cash,without incurring in losses, typical liabilities of banks and financial firms are more liquid and imply aconsiderable degree of discretion as far as the timing of depositors’ withdrawal.Thus, there are different elements to consider in order to analyse the liquidity of a financialfirm. On one hand, traditional financial intermediation is based on different degree of discretionary power as far as the timing of use of funds. Consequently, the bank must maintain the confidence of depositors to have the faculty to withdraw their deposit on demand or at the scheduled moment. On theother hand, contemporary banking is based on more innovative financial services, which can also affectthe capability of a bank to be liquid, as it has been demonstrated in 2007 financial crisis. The increasein the complexity of financial instruments, the securitisation, the growth of collateral usage and thetrend to raise funds on wholesale capital markets are, among others, some of the reasons underlying theincrease in the complexity of liquidity management in the financial firms.In the light of above, liquidity risk can be considered as the risk that a financial firm, thoughsolvent, either does not have enough financial resources to allow it to meet its obligations as they falldue, or can obtain such funds only at excessive cost. However, different institutions and authors, indiverse moments, highlighted several different features in defining liquidity risk. First of all, accordingto a supervisory approach, the Basel Committee on Banking Supervision since 1992 made the effort todefine ‘A Framework for Measuring and Managing Liquidity’, stressing the fact that supervisoryauthorities have to differentiate the approaches for large international banks and domestic ones, as wellas proposing different methodologies based alternatively on maturity ladder or scenario analysis inorder to implement an effective liquidity management. Eight years later, the Basel Committee onBanking Supervision (2000) simply defined the liquidity as ‘the ability to fund increases in assets andmeet obligations as they come due’; in this framework, the Committee illustrated the evolutions inliquidity management and supervision, stressing, in fourteen key principles, the importance to designdifferent managerial solutions for the day-to-day management of liquidity compared to the approachesto be adopted in emergency situations and the relevance to measure and monitor the net fundingrequirements. However, also this second paper did not identify dominant methodologies in order toassess and to manage liquidity risk. Nevertheless, the paper has the merit to clearly link, for the firsttime, liquidity risk to other typical risks of banking business, like credit risk, market risk andoperational risk, as well as it dedicated a significant space to the importance of contingency plansagainst liquidity shocks.
In 2006 The Joint Forum of the Basel Committee integrated the principles divulgated in 2000, proposing an ‘integrate liquidity risk management across sectors’ in financial groups, also consideringthe impact on liquidity of the off-balance sheet instruments and of on-balance sheet contracts withembedded optionality
. In this framework, following a classification previously adopted by theEuropean Central Bank (2002), the Joint Forum differentiated the liquidity risk in
funding liquidity risk
(as ‘the risk that the firm will not be able to efficiently meet both expected and unexpected current andfuture cash flow and collateral needs without affecting either daily operations or the financial conditionof the firm’) and
market liquidity risk
(which is ‘the risk that a firm cannot easily offset or eliminate a position without significantly affecting the market price because of inadequate market depth or marketdisruption’). From this paper onwards, such distinction between funding liquidity risk and marketliquidity risk became a common element in all the literature on liquidity risk management. However,still in 2006 the managerial practices adopted by banks for facing liquidity risk continued to besignificantly differentiated and also supervisory authorities persisted to adopt dissimilar andheterogeneous models in order to assess the liquidity profiles of financial institutions.
See par. 4.
These are contracts imply an implicit options for the counterparty, which can determine a liquidity outflow.