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A central difficulty with discussing issues relating to liquidity is the lack of consensus on what it means. Liquidity is clearly multifaceted and perhaps also a somewhat loosely employed economic concept. To capital market participants, liquidity generally refers to transaction costs arising from bid-ask spreads, price impacts, and (limited) market depth for trading in securities. By token, liquidity risk for this segment of market participants generally refers to unpredictable variations in transaction costs. I shall henceforth refer to this notion of liquidity and liquidity risk as pertaining to “market liquidity”. In contrast, and often times in addition, risk managers at banks and financial institutions are concerned about liquidity on the funding side. This pertains to the ease with which cash shortfalls of the enterprise can be funded through various sources of financing – internal or external – that the enterprise has access to. I shall refer to this as “funding liquidity” and its unpredictable fluctuations over time as funding liquidity risk.

In what follows, I first examine why banks should be concerned about liquidity risk. Next, I argue that the two forms of liquidity are highly intertwined and that both are preceded by significantly large shocks to asset prices in capital markets of the economy. I conclude by examining implications of these observations for risk management at banks.

I Funding Liquidity Risk:What Should Banks and Financial Institutions Be Concerned About?

With market risk and credit risk, you could lose a fortune. With [funding] liquidity risk, you could lose the bank!

– Bruce McLean Forrest, UBS Group Treasury.

Put simply, funding liquidity risk is the risk that an institution will have to meet uncertain cash requirements in future arising from its day-to-day business activities. There are two primary sources of funding liquidity risk: cash outflows that arise during periods of systematic asset or liquidity shocks, and those that arise due to idiosyncratic or institution specific shocks. Systematic asset shocks arise during recessions (e g, the Great Depression), oil price shocks (e g, of mid1970s), stock market crashes (e g, in the US in 1987) and real estate crashes (e g, in Japan in late 1980s). Systematic liquidity shocks such as the stock market crash in 1987 and the Long-Term Capital Management episode in 1998 often coincide or are preceded by asset market shocks. However, it is safe to assume that there is a shock to cash flows in these periods due to market illiquidity (wider bid-ask spreads, greater haircuts on collateral – discounts charged by lenders when one is borrowing against marketable securities, and the complete inability to trade some instruments) – shocks that are not attributable purely to asset shocks.

In contrast, idiosyncratic or institution specific shocks may arise due to fraud, disclosure of accumulated losses or accounting irregularities, legal settlements, significant model risk, poor risk management and the resulting loss of reputation in capital markets, and perhaps to a smaller extent, due to idiosyncratic asset shocks (more relevant for regional or community banks). Even if such shocks are not accompanied by market-wide liquidity shocks, a disorderly liquidation of assets could produce end outcomes for the affected institution that could resemble those in times of market-wide shocks.

The key question to ask is: What happens to the institution’s funding sources in the wake of a systematic or idiosyncratic liquidity shock? The answer to this question depends crucially on the modernday financial regulatory environment and also on the nature of the bank – commercial or not.

Specifically, a recent study by Gatev and Strahan (2005) shows that during times

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Economic and Political Weekly February 11, 2006

Figure: Standarised Innovations in Market Illiquidity from 1964-1999 an extent the distress of Long-Term

5 4 3 2 1 0 –1 –2 –3

Innovations in Market Illiquidity

1960 1965 1970 1975

Source: Acharya and Pedersen (2005).

of systematic liquidity shocks, there is a “flight to quality” of deposits to commercial banks. The authors measure systematic liquidity shocks by a widening of the (non-financial) commercial paper to treasury bill spread (the so-called “paper-bill spread”). The paper bill spread is considered a good proxy for times when liquidity (and default) risk rises, as evidenced during the Penn Central default in 1970, LTCM episode in 1998, and recently, the Enron bankruptcy in 2002. The authors find that when the paper-bill spread widens, commercial banks in the US experience an increase in deposit inflow. What is also interesting to note is that such effects were not prevalent in the period prior to the introduction of deposit insurance in the US. For example, during the Great Depression of 1929-33, there was a wide-scale of conversion of deposits into currency, resulting in one of the sharpest monetary and lending contractions (and, in fact, paving way for the establishment of federal deposit insurance in the US).

This finding suggests that the regulatory deposit insurance is an important (even if partial) hedge that deposit bearing commercial banks have against systematic liquidity shocks. While US stands out in its somewhat large deposit insurance coverage, the size of deposit insurance is non-trivial in most other economies as well (barring a few exceptions like Australia and New Zealand where deposit insurance is not prevalent, but talks about it being introduced in these countries also are currently underway).1

1980 1985 1990 1995 2000

Date

However, for institutions other than

commercial banks such as brokerage

houses, hedge funds and the like, and

even for commercial banks when liquidity

needs are of an intra-day basis (for ex

ample, due to collateral requirements or

margin calls on traded securities), other

forms of funding become crucial to avoid

ing a liquidity crisis. In addition to depos

its, banks and financial institutions can

rely on external forms of financing such

as equity, subordinated debt, unsecured

inter-bank credit, secured debt against

collateral and undrawn lines of credit, and

on internal financing in the form of cash

and retained earnings.

The price-sensitive funding sources –

equity, subordinated debt, and unsecured

inter-bank credit – are in fact almost

completely unavailable to institutions

which have experienced idiosyncratic

liquidity shocks. The very fact that the

shock is idiosyncratic renders financing

of the institution difficult: central bank

support is unlikely in case of an isolated

liquidity problem (unless the institution

is too-big-to-fail), there is a loss of

reputation in making losses when other

institutions have done well (there is no

one to “share the blame with”), the

opaqueness of typical bank balance sheet

aggravates the matter by blurring the

boundary between insolvency and

illiquidity, and the institution’s manage

ment as well as risk management practices

come into question. Some cases in point

here are Continental Illinois’s collapse in

1989, the Barings disaster in 1995, and to Capital Management in 1998 in spite of its pre-existing complex web of relationships for borrowing against collateral at small haircuts.

In essence, price-sensitive funding sources are rendered either unviable or too expensive during idiosyncratic liquidity shocks to institutions. Although, retained earnings and undrawn lines of credit represent price-insensitive sources of funding, these have to be arranged in advance and may not constitute a liquidity buffer that is large enough in the wake of a significant liquidity shock. The material adversity clauses (MACs) in the lines of credit are more likely to invoked if the liquidity needs of the affected institution are easier to attribute to internal (idiosyncratic) problems rather than external (systematic) ones. The institution would thus typically have to resort to at least some form of intermediate financing, such as secured borrowing against collateral. The extent of such borrowing that can be undertaken depends upon the market value of the collateral and the size of haircuts being charged by counterparties (typically, 2-5 per cent for highly liquid assets like OECD government bonds, 10-25 per cent for highly-rated industrials and 25-50 per cent for illiquid assets like major-index equities, but generally higher during liquidity crises). The variation in haircuts over time, and, in turn, in collateral values, creates a role for market liquidity in determining the institution’s funding liquidity risk.

Economic and Political Weekly February 11, 2006 illiquidity; the covariance of a security’s return or price changes with market-wide illiquidity; and, the covariance of a security’s illiquidity with market-wide return. The enclosed figure from Acharya and Pedersen (2005) plots the timeseries of innovations (unpredictable shocks) in stock market illiquidity computed using the daily price-impact measure of Amihud (2002) over the period 1964-2000, a measure that has been shown by Amihud (2002) to be related to other measures of liquidity such as the bid-ask spread.

Strikingly, liquidity shocks are highly episodic. That is, innovations in market illiquidity are generally small but quite high during the few periods that anecdotally were characterised by liquidity crisis, for instance, in 5/1970 (Penn Central commercial paper crisis), 11/1973 (oil crisis), 10/1987 (stock market crash), 8/1990 (Iraqi invasion of Kuwait), 4-12/1997 (Asian crisis) and 6–10/1998 (Russian default and Long-Term Capital Management crisis). Many of these coincide with negative asset value shocks, highlighting the correlation of market-wide illiquidity with negative shocks to market-wide returns. The relative size of illiquidity peaks to average illiquidity also illustrates that when illiquidity does rise, it tends to dry up suddenly, inducing a non-linear or regime-switching relationship between liquidity shocks and asset return shocks, an observation whose likely roots will be explored further in the discussion that follows.

Furthermore, Acharya and Pedersen (2005) find that securities that do exhibit substantial liquidity covariances or betas in the above sense are also more illiquid on average. To emphasise, illiquid securities (such as equities) tend to become more illiquid during market-wide asset and liquidity shocks. This is also true for individual stocks within the broad class of equities.

The importance of this result stems from three observations: First, asset shocks and liquidity shocks occur together, accentuating the overall impact of funding liquidity risk; second, when funding liquidity risk rises, the market value of certain forms of collateral may fall as well; and, third, when funding liquidity risk rises, haircuts on collateral may rise too since funding liquidity risk arises when there is market liquidity risk too. For instance, haircuts on AAA-rated commercial mortgages jump up from 2 per cent in normal times to 10 per cent during stress times limiting their usefulness as collateral for secured funding. In another instance highlighting the correlation of market and funding liquidity risks, as many as 12 NYSE specialist firms had no buying power whatsoever on October 19, 1987, during the stock market crash, due to lack of capital for posting margins on additional transactions.

To summarise, the real funding liquidity risk is that if it coincides with market liquidity risk and asset return risk (and I argued above that it often will) then it could render an institution and its collateral illiquid when the cash inflows from flight to quality are not sufficient to overcome its heightened funding needs, especially on an intra-day basis. If a specific institution suffers more adversely than others due to differential risk exposure or due to a compounding of asset shocks with managerial and risk management issues, then the institution may not benefit from flight to quality effects, and the effect of funding liquidity risk may be more pernicious.

In order to understand the implications of this discussion further, it is useful to step back and ask the question: what causes market liquidity to be lower during times of large asset shocks? The explanation has perhaps been best expounded in a recent paper by Brunnermeier and Pedersen (2005) who start from the premise that due to the presence of haircuts, that is, due to the inability to borrow against the entire market value of securities, trading requires capital. Asset shocks reduce the amount of capital available with capital-market intermediaries (specialist firms and hedge funds, which are unlikely to benefit from flight to quality, and universal banks, which may only partially benefit from flight to quality). This, in turn, lowers the ability of their trading desks to provide liquidity in the form of narrow bid-ask spreads, smaller price impacts, and greater depth. As liquidity in the market worsens, the funding ability of intermediaries, whose revenues, wholly or partly, consist of market-making revenues, worsens too. This worsening of funding ability in turn limits their liquidity provision role even further, giving rise to a downward spiral, and a sudden drop in both the funding liquidity of intermediaries and the market liquidity they provide. To summarise, if the asset shock is large enough so that the capital position of a sufficiently large number of intermediaries is rendered constrained, then

Economic and Political Weekly February 11, 2006

a sudden dry up of both funding and market liquidity may arise.

In my view, the presence of such a link between funding and market liquidity risks implies that prices in capital markets exhibit two “regimes”. In the normal regime, intermediaries are well capitalised and liquidity effects are minimal: prices of assets reflect fundamentals and no (or little) liquidity effect. Thus, the correlations across asset prices in these times are also driven primarily by correlation in fundamentals of the underlying entities or risks. In the illiquidity regime, intermediaries are close to their financing or capital constraints and prices now reflect the “shadow” cost of capital to these intermediaries, i e, the cost they suffer from issuing an additional unit of funding capital to undertake a transaction. In economic parlance, there is “cash-in-the-market” pricing, that is, the total liquid capital of market participants in a particular security market affects the price of that security. Since this liquidity effect (the illiquidity discount) is related to intermediaries’ capital rather than to fundamentals of the security, it affects prices of securities traded by these intermediaries across the board, inducing a correlation in securities’ market prices that is over and above the one induced by fundamentals. In other words, the interaction of market liquidity risk and funding liquidity risk, and their common genesis in asset shocks, induces “correlation risk” in the market, above and beyond that implied by correlation in fundamentals.2

III Implications for RiskManagement at Banks andFinancial Institutions

In this section, I examine some of the operational issues of liquidity risk management. It is interesting that many banks and financial institutions do consider liquidity risk as a separate source of risk in their risk management. Furthermore, typical liquidity risk is managed by projections of cash flows and funding sources based on stress tests and scenarios (for example, going concern scenario, liquidity squeeze, bank specific crisis, general market crisis, with additional qualifications based on currency specific, market-specific, sector specific and country specific risks). While these specifics of liquidity risk management process do warrant careful attention, especially for institutions and their risk management desks, I focus here on a final set of broad observations.

What are the merits of treating liquidity risk as a separate source of risk? As argued earlier, liquidity issues are generally followed by asset shocks of some sort. The covariance between liquidity risk and asset return risk must thus be taken into account. A catch here is that liquidity risk is typically highly non-linear in asset return risk. The feedback between funding and market liquidity risks makes this problem particularly severe from the standpoint of capturing liquidity risk adequately by merely appealing to asset return risk, and recognising that liquidity risk may be correlated with it. On the one hand, this discussion implies that liquidity risk can be partly hedged by better management of asset return risk. Nevertheless, complete hedging of liquidity risk may be economically infeasible and most likely too expensive. On the other hand, the discussion also implies that liquidity risk does have a “sudden” or a “jump” component to it, which may be best hedged against by some kind of stress or scenario analysis, similar to the current practice at banks and financial institutions.

I believe however that tying the modelling of stress scenarios for liquidity risk to the institution’s asset return risk would be fruitful for risk management desks. A good example is based on correlation risk. As discussed earlier, correlation risk can arise from liquidity affecting prices of a spectrum of securities during stress times. Correlation risk is typically considered a trading desk level risk. However, when correlations are induced by market liquidity, correlation risk is most likely to be associated with funding risk at the overall firm level. If funding risk and correlation risk are positively correlated (depending on being long or short correlation), then the stress scenarios may be more adverse than the ones anticipated based on funding risk alone. By the same token, if funding risk and correlation risk are negatively correlated, lack of modelling of this association would lead to over-hedging in the form of excessively large cash or buffers of quality collateral.

While it is a long way before liquidity risk and induced correlation risk can be simplified enough to come up with tractable models (such as CAPM) that can be used in practice, I hope that the discussion in this article serves as a useful reality check for current risk management practices aimed at managing liquidity risk and stimulates research that takes us closer to that long-term goal. Email: vacharya@london.edu

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Notes

1 In addition to deposit insurance, central bank intervention and guarantees are more likely to be brought into play during market-wide crises. Hoggarth, Reidhill and Sinclair (2004) study resolution policies adopted in 33 banking crises over the world during 1977-2002. They document that when faced with individual bank failures, regulatory authorities have usually sought a private sector resolution where the failed institution is generally sold to one of the surviving ones, and its losses are typically passed onto existing shareholders, managers and sometimes uninsured creditors, but almost always not to taxpayers. However, government involvement has been an important feature of the resolution process during systemic crises: at early stages, liquidity support from central banks and blanket government guarantees have been granted, usually at a cost to the fiscal budget; bank liquidations have been very rare and creditors have rarely made losses.

2 Such effects were observed in the global capital markets in May 2005 in the wake of GM and Ford downgrades. A large number of financial institutions ended up with inventory of GM and Ford debt due to the limited capacity (regulatory restrictions) for holding of junk quality corporate paper. These institutions thus bore significant liquidity risk on their inventory and started charging discounts in other markets too, such as the credit derivatives market. As a result, the auto sector paper (of GM and Ford) appeared to be correlated with the credit default swap prices in the financial institutions sector (with the largest banks as the underlying reference entities).

References

Acharya, Viral V and Lasse H Pedersen (2005): ‘Asset Pricing with Liquidity Risk’, Journal of Financial Economics, 77(2), August, pp 375-410.

Amihud, Yakov (2002): ‘Illiquidity and Stock Returns: Cross-Section and Time-Series Effects’, Journal of Financial Markets, 5, pp 31-56.

Brunnermeier, Markus and Lasse H Pedersen (2005): ‘Market Liquidity and Funding Liquidity’, Working Paper, Stern School of Business, New York University.

Gatev, Evan and Philip E Strahan (forthcoming): ‘Banks’ Advantage in Hedging Liquidity Risk: Theory and Evidence from the Commercial Paper Market’, Journal of Finance.

Hoggarth, Glenn, Jack, Reidhill and Peter Sinclair (2004): ‘On the Resolution of Banking Crises: Theory and Evidence’, Working Paper 229, Bank of England.