“Everything that can be counted does not

necessarily count; everything that counts cannot

necessarily be counted.”
Albert Einstein

Contemporary Financial
Intermediation

Chapter 6. Liquidity
Risk
Key Questions

• What is liquidity risk?

• Should banks bear liquidity risk?

• How can liquidity risk be reduced?

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Stuart I. Greenbaum, Anjan V. Thakor, and Arnoud W.A. Boot
Liquidity Risk

• Liquidity risk refers to the institution being

unable to replace maturing liabilities at
reasonable cost.

• It is manifested in a drying up of funding,

making it difficult for the institution to keep
investing in its asset portfolio.

• During the 2007-09 financial crisis, many

“shadow banks” found themselves unable
to roll over short-term funding. Bear Sterns
had to be bailed out and Lehmann Brothers
failed.

Contemporary Financial Intermediation

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Stuart I. Greenbaum, Anjan V. Thakor, and Arnoud W.A. Boot
Formal Definitions
of Liquidity
• Let P* be the full-value price of an asset and Pi ( P*)
be the price realized, where i = 0, …, n indicates the
time used for marketing, and n is the time needed to
realize P*
Pi
L1 =
P*
1 n Pi
L2 = � *
n i =1 P

• Now, view i as a random

n variable with a probability
E ( P )
distribution, g(i) �= g ( i ) Pi
i =0

E ( P)
L3 =
P*

• Next, account f ( i, M
Pi = for ,P )
marketing
*
expenditure, M
n
E ( P ) = �g ( i ) f ( i, M , Pi )
'
Optimally
i =0 chosen M
E ( P' )
L4 =
P*

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Stuart I. Greenbaum, Anjan V. Thakor, and Arnoud W.A. Boot
Reducing Liquidity Risk
• With liquid assets
– Investing in more liquid loans
– Keeping more cash one hand
– Liquidity improved at the expense of profits

• By dissipating withdrawal risk

– Diversifying the sources of funding, i.e., having a
diverse depositor base
– Yet, still some (even small) probability that
withdrawals exceed the bank’s capacity to service
them
– Keeping healthy capital levels so financiers worry
less about insolvency-risk.

• With a Lender of Last Resort (LLR)

– Motivation for the creation of central banks
– Sound but illiquid banks can be protected
– Moral hazard: bank’s incentive to hold cash assets
and diversify deposit base is weakened

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Stuart I. Greenbaum, Anjan V. Thakor, and Arnoud W.A. Boot
Liquidity Risk Interacts
with other Risks
• Interaction between liquidity and default
risks.

• Interaction between liquidity and interest

rate risks.

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Stuart I. Greenbaum, Anjan V. Thakor, and Arnoud W.A. Boot
Difficulty of Distinguishing
between Liquidity and
Insolvency Risk
• In practice, it is often hard to tell whether
an institution cannot replace lost funding
because there is a market-wide shortage of
liquidity or because the institution is
viewed as insolvent.

• Thus, what may be viewed as a “liquidity

crisis” may actually be caused by
insolvencies of institutions (see Chapter 14
on the 2007-09 financial crisis). Not
recognizing this can lead to errors in the
nature of regulatory intervention to solve
the problem.

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Stuart I. Greenbaum, Anjan V. Thakor, and Arnoud W.A. Boot
Conclusion

• Managing liquidity risk is a part of the core

competencies of banks, so banks will bear
this risk.

• However, liquidity risk can be managed by:

keeping liquid assets, diversifying funding
sources, accessing a lender of last resort
and by keeping healthy capital levels.

• Liquidity risk interacts with credit risk and

interest rate risk- justifying the use of ERM
to manage these correlated risks.

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Stuart I. Greenbaum, Anjan V. Thakor, and Arnoud W.A. Boot