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Homework answers / question archive / Throughout the global financial crisis which began in mid-2007, many banks struggled to maintain adequate liquidity
Throughout the global financial crisis which began in mid-2007, many banks struggled to maintain adequate liquidity. Unprecedented levels of liquidity support were required from central banks to sustain the financial system and even with such extensive support several banks failed, were forced into mergers or required resolution.” (BCBS 165). Using this statement
You may refer CBO Circular BM 955
The word limit for this answer including intext references is 600 words.
a)
importance of sound liquidity management within banks
Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk,2 both of an institution-specific nature and that which affects markets as a whole. Virtually every financial transaction or commitment has implications for a bank’s liquidity. Effective liquidity risk management helps ensure a bank's ability to meet cash flow obligations, which are uncertain as they are affected by external events and other agents' behaviour. Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial market developments in the past decade have increased the complexity of liquidity risk and its management.
In order to account for financial market developments as well as lessons learned from the turmoil, the Basel Committee has conducted a fundamental review of its 2000 Sound Practices for Managing Liquidity in Banking Organisations. Guidance has been significantly expanded in a number of key areas. In particular, more detailed guidance is provided on:
• the importance of establishing a liquidity risk tolerance;
• the maintenance of an adequate level of liquidity, including through a cushion of liquid assets;
• the necessity of allocating liquidity costs, benefits and risks to all significant business activities;
• the identification and measurement of the full range of liquidity risks, including contingent liquidity risks;
• the design and use of severe stress test scenarios;
• the need for a robust and operational contingency funding plan;
• the management of intraday liquidity risk and collateral; and • public disclosure in promoting market discipline.
This guidance focuses on liquidity risk management at medium and large complex banks, but the sound principles have broad applicability to all types of banks. The implementation of the sound principles by both banks and supervisors should be tailored to the size, nature of business and complexity of a bank’s activities. A bank and its supervisors also should consider the bank’s role in the financial sectors of the jurisdictions in which it operates and the bank’s systemic importance in those financial sectors. The Basel Committee fully expects banks and national supervisors to implement the revised principles promptly and thoroughly and the Committee will actively review progress in implementation.
b)
Liquidity is a term used to refer to how easily an asset or security can be bought or sold in the market. It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.
Funding Liquidity Risk
Funding or cash flow liquidity risk is the chief concern of a corporate treasurer who asks whether the firm can fund its liabilities. A classic indicator of funding liquidity risk is the current ratio (current assets/current liabilities) or, for that matter, the quick ratio. A line of credit would be a classic mitigant.
Market Liquidity Risk
Market or asset liquidity risk is asset illiquidity. This is the inability to easily exit a position. For example, we may own real estate but, owing to bad market conditions, it can only be sold imminently at a fire sale price. The asset surely has value, but as buyers have temporarily evaporated, the value cannot be realized.
Consider its virtual opposite, a U.S. Treasury bond. True, a U.S. Treasury bond is considered almost risk-free as few imagine the U.S. government will default. But additionally, this bond has extremely low liquidity risk. Its owner can easily exit the position at the prevailing market price.Small positions in S&P 500 stocks are similarly liquid. They can be quickly exited at the market price. But positions in many other asset classes, especially in alternative assets, cannot be exited with ease. In fact, we might even define alternative assets as those with high liquidity risk.
Measures of Market Liquidity Risk
There are at least three perspectives on market liquidity as per the above figure. The most popular and crudest measure is the bid-ask spread.2? This is also called width. A low or narrow bid-ask spread is said to be tight and tends to reflect a more liquid market.
Depth refers to the ability of the market to absorb the sale or exit of a position. An individual investor who sells shares of Apple, for example, is not likely to impact the share price. On the other hand, an institutional investor selling a large block of shares in a small capitalization company will probably cause the price to fall. Finally, resiliency refers to the market's ability to bounce back from temporarily incorrect prices.
To summarize:
MANAGING LIQUIDITY RISK
In the case of exogenous liquidity risk, one approach is to use the bid-ask spread to directly adjust the metric. Please note: Risk models are different than valuation models and this method assumes there are observable bid/ask prices.
Liquidity risk can be parsed into funding (cash-flow) or market (asset) liquidity risk. Funding liquidity tends to manifest as credit risk, or the inability to fund liabilities produces defaults. Market liquidity risk manifests as market risk, or the inability to sell an asset drives its market price down, or worse, renders the market price indecipherable. Market liquidity risk is a problem created by the interaction of the seller and buyers in the marketplace. If the seller's position is large relative to the market, this is called endogenous liquidity risk (a feature of the seller). If the marketplace has withdrawn buyers, this is called exogenous liquidity risk—a characteristic of the market which is a collection of buyers—a typical indicator here is an abnormally wide bid-ask spread.
A common way to include market liquidity risk in a financial risk model (not necessarily a valuation model) is to adjust or "penalize" the measure by adding/subtracting one-half the bid-ask spread.
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