Liquidity Risk

Liquidity, which we define broadly as the availability of cash or equivalent resources, is the lifeblood of every commercial and sovereign entity. Liquidity allows expected and unexpected obligations to be met when needed so that daily business affairs can proceed uninterrupted. In the absence of sufficient cash resources activities may be jeopardized; more importantly, the probability of encountering more severe financial distress increases. Liquidity is therefore a vital element of financial management and must be considered and managed with care. In this introductory chapter we begin our review of liquidity by examining definitions of liquidity risk, and considering liquidity risk in relation to general corporate operations and other dimensions of financial exposure. We also outline key themes we intend to explore in the balance of the text.

With some background on liquidity and its associated risks, we are now prepared to review the role of liquidity in financial operations. By examining concepts related to the operating environment we come to understand the importance of liquidity from an internal and systemic perspective, which will be useful when we consider liquidity-induced problems in Part II of the book. In this chapter we explore liquidity operating requirements, the liquidity risk/return trade-off, liquidity characteristics across industries, and endogenous versus exogenous liquidity.

As we consider liquidity risks and the challenges that can arise from an asset and funding perspective, it is helpful to begin by analyzing sources of liquidity that firms from a broad range of industries can access in support of their operations. This provides an understanding of how liquidity structure must be managed to ensure availability of cash resources when needed. In this chapter we review sources of liquidity found in the asset and liability accounts of the balance sheet, as well as those that exist off-balance sheet. We also discuss the amalgamated picture of liquidity, in both theoretical and actual terms.

We begin our discussion of theoretical and practical liquidity risk problems with an analysis of funding liquidity risk, which we have previously defined as the risk of loss stemming from an inability to obtain unsecured funding at economically reasonable levels when needed. If short and long-term debt facilities and off-balance sheet contingencies cannot be accessed as required, a firm might experience funding losses; when coupled with the asset liquidity risk problems discussed in the next chapter, more serious instances of financial distress can develop.

As we continue with our discussion of the theoretical and practical nature of liquidity risk problems, we turn our attention to asset liquidity risk, which we have defined as the risk of loss arising from an inability to convert assets into cash at carrying value when needed. Asset liquidity risk is sometimes known as market liquidity risk, since the process relates to the market price that is assigned to, and can be obtained by, a portfolio of assets. In fact, the market value of an asset has two primary sources of risk: the uncertainty of asset returns (that is, pure market risk) and the uncertainty of liquidity risk (that is, pure liquidity risk), and the two may be strongly correlated.

We have examined the difficulties that can arise with asset and funding risks, and extend the theme in this chapter by analyzing instances of financial distress that can arise from joint asset/funding liquidity problems. We know from previous chapters that difficulties in raising funding or selling/pledging assets can produce losses. While such losses can be serious, widespread financial damage can generally be contained. However, in some cases asset and funding difficulties combine to create a much more dire scenario. Specifically, when asset and funding liquidity risks join together, a liquidity spiral — or a cycle where attempts to secure additional liquidity come at an increasing cost and a decreasing level of flexibility — can develop. Once a liquidity spiral has commenced, each new attempt to source cash becomes more critical, difficult, and costly. A company caught in a spiral must deal forcefully with the crisis or risk sliding into financial distress and possible insolvency.

In the last three chapters we have explored concepts of liquidity risk and the financial losses that can arise from such exposures. In this chapter we extend our discussion by exploring a select number of “real world” case studies that help illustrate different dimensions of liquidity risk and the degree of damage that can be wrought.

In the first two parts of this book we have considered why liquidity is so vital to corporate operations and illustrated what can go wrong, in theory and practice, if it is mishandled. The degree of financial damage that can arise varies. In some cases it may be limited to losses from higher funding costs or asset disposals at prices below carrying value; in other cases it may be more serious, extending to instances of financial distress and insolvency. Every entity exposed to liquidity risk must therefore attempt to avoid damage through a liquidity risk management process. An effective framework, our topic in this part of the text, is based on a number of fundamental elements. In this chapter we discuss the measurement of liquidity risk through various tools, in Chapter 9 we consider ways of managing liquidity risk as part of the corporate process, and in Chapter 10 we discuss the development and implementation of a liquidity crisis management plan. We summarize key thoughts on active liquidity risk management in Chapter 11.

We know from our discussion in previous chapters that active management of liquidity risk is central to a company’s success. A well-structured approach to managing risks that have been identified and measured helps a company avoid the cash flow surprises that can lead to problems. Liquidity risks can be managed through a multi-stage stage process that is based on developing proper governance practices, defining and implementing a liquidity risk mandate, assigning management duties and responsibilities, creating and implementing liquidity risk controls, and monitoring the liquidity risk profile. We consider each of these essential points, summarized in Figure 9.1, in greater detail in this chapter.

A firm operating under normal market circumstances will be able to rely on its mandate, policies, and limits to control the liquidity exposures inherent in its business. If these mechanisms are structured properly and followed diligently, the financial impact of the exposures should remain manageable. However, there may still be instances when endogenous or exogenous factors overwhelm the firm, giving rise to the possibility of greater financial problems and even instances of financial distress. In such extraordinary cases a firm must immediately implement a liquidity crisis management program. A successful program allows a company to move beyond the crisis stage and normalize its operations at a minimum of cost; an unsuccessful program — or indeed the lack of any program at all — can lead to complications, including liquidity spirals and insolvency. In this chapter we consider the scope and focus of liquidity crisis management, ex ante market access, defensive measures, communications, trigger events, disaster recovery, and plan testing.

As we conclude our review and analysis of liquidity risk, we consider the prospects for active liquidity risk management over the medium term. It is clear that companies (and sovereigns) have become more attuned to risks and risk management over the past two decades: volatile markets, dislocations, systemic stresses, and resulting losses have played an important part in heightening risk awareness, generally to good effect. With little to indicate that the economic and financial operating environment will become more benign in coming years, rigorous risk management will remain essential.