Liquidity risk · RiskAtoms Academy

By the end you will be able to

1Tell funding liquidity risk apart from market liquidity risk.
2Explain how each feeds the other in a liquidity spiral.
3Work out the cost of raising cash in a fire sale, and a simple survival horizon.
4Explain why a solvent firm can still fail for lack of cash.

Why it matters

Banks rarely fail because they run out of value. They fail because they run out of cash, often in a matter of days, sometimes while their assets are still worth more than their debts.

Core explanation

Cash today, and the price of getting it

L1.1.07: Market liquidity split liquidity into two ideas. Liquidity risk is what happens when either one runs short.

Funding liquidity risk

Can we pay what we owe today?

The risk of not being able to meet payments and collateral calls when they fall due. A bank faces it when depositors withdraw or lenders refuse to roll over. A fund faces it when it gets a margin call. It is about the liability side and timing.

Market liquidity risk

Can we sell this without a big price cut?

The risk of not being able to sell or hedge a position quickly near its market price. It grows when markets are thin, when everyone wants to sell at once, or when the position is large. It is about the asset side and price.

A firm with plenty of cash can wait out a thin market. A firm with liquid assets can raise cash fast. Trouble starts when both go wrong together, and they tend to, because each one feeds the other.

The spiral. Take a fund that owns bonds funded partly with repo (L1.6.04: Repo and securities financing). The lender lends the bonds' value minus a haircut; the fund's own money covers the rest. Now bond prices dip.

The bonds are worth less, so the lender lends less against them (funding shrinks).
Prices are jumpier, so the lender raises the haircut (funding shrinks again).
The fund must sell bonds to repay what it can no longer borrow (a forced sale).
If many funds sell at once into a thin market, prices fall further (market liquidity dries up).
Back to step 1, with lower prices.

Economists Markus Brunnermeier and Lasse Pedersen called this a liquidity spiral: a loss spiral as falling prices eat the fund's equity, and a margin spiral as lenders demand more collateral. You will step through one in Try it below.

TimelineUK pension funds, autumn 2022

1 / 5

Before

Hedged with leverage

Many UK defined benefit pension schemes used liability-driven investment (LDI) funds. These held long-dated gilts and interest rate swaps, often with borrowed money or repo, to match their long pension promises. If gilt yields rose, the funds owed collateral on the swaps and repo.

Sort itFunding or market liquidity?

Depositors withdraw £5bn from a bank in two days after a rumour on social media.
A fund can only sell its corporate bonds at 4 points below the screen price.
A clearing house raises initial margin on oil futures, and a trader must post more cash by tomorrow.
A bank's 'liquid' bonds turn out to be hard to sell in a stress, so it can raise less cash from them.
Lenders refuse to renew a company's commercial paper when it matures.

On Example Group's balance sheets, liquidity risk sits on both sides: cash and bonds are the buffer; deposits and short-term wholesale funding are where the cash can leave.

ExploreExample Group: where the risks sit

Pick a risk type to light up the lines that carry it. Pick a line to see why.

Example Bank plc

£ billions · assets carrying liquidity risk: £150bn (30%)

Assets

Liabilities

Example Insurance SE

€ millions · assets carrying liquidity risk: €2,000m (3%)

Assets

Liabilities

Liquidity risk

The risk of being unable to pay what is due on time without unacceptable cost, or of being unable to sell assets without a large price cut.

Where this goes next

M3.4: Liquidity risk and funding covers cash flow ladders, survival horizons, buffers and contingency funding plans. The liquidity rules for banks, the LCR and NSFR, are calculated in M4.5: Liquidity and IRRBB regulation.

The formal version

Two pieces of liquidity arithmetic

Both are simple ratios, shown in full. If a fire sale costs a discount $d$ , raising cash $C$ means selling more than $C$ of assets:

\text{assets sold} = \frac{C}{1-d}, \qquad \text{cost of the sale} = \frac{C}{1-d} - C

A survival horizon asks how long the liquidity buffer lasts if the outflows keep coming:

\text{survival horizon (days)} = \frac{\text{buffer after haircuts}}{\text{net outflow per day}}

Regulators turn the same idea into a rule. The liquidity coverage ratio compares a bank's high-quality liquid assets with its net outflows over a 30-day stress:

\text{LCR} = \frac{\text{high-quality liquid assets}}{\text{net cash outflows over 30 days of stress}} \geq 100\%

Try it

A fund holds £100m of bonds with £10m of its own money. At the starting settings, a 3% price fall costs £3m on its own. The spiral that follows forces it to sell £69m of bonds, pushes the price down 9.5% in all, and leaves £3.7m of equity. Step through it, then make the market deeper: with a price fall of 0.2% per £10m sold, the fund keeps £6.5m. Then make it thinner and watch the fund fail.

Try itStep through a liquidity spiral

First fall in bond prices3.0%

Market depth: price fall per £10m sold1.0%

Lenders raise haircuts by (pp per 1% price fall)0.5

The fund starts with £100m of bonds, £10m of its own money and £90m of repo at a 10% haircut. Each round lenders mark the bonds to market, the haircut is reset, and the fund sells whatever its equity can no longer support.

Prices have just fallen 3.0%: a loss of £3.0m on its own. Press “Start the spiral”.

Notice that faster-rising haircuts make the fund sell more, earlier, and push the price lower for everyone else holding the same bonds. That is how one firm's funding problem becomes the whole market's liquidity problem.

Worked example

A stressed month at Example Bank plc

A rumour about Example Bank plc spreads. Over a month, 15% of its customer deposits leave, and 40% of its short-term wholesale funding is not renewed. It meets the outflows first from cash, then by selling securities. Balance sheet figures from L1.8.02: A bank’s balance sheet, £bn.

Funding need, then the cost of market liquidity

Step 1 of 6

1
The outflows
Deposits: 15% × £330bn = £49.5bn. Wholesale: 40% × £25bn = £10.0bn. Total £59.5bn.

Regulatory lens

Principles: the Basel Committee's Principles for Sound Liquidity Risk Management and Supervision (2008) set out how banks should manage liquidity, written as the 2007 to 2008 crisis unfolded.
Two ratios: Basel III added the liquidity coverage ratio (survive 30 days of stress) and the net stable funding ratio (fund long-term assets with stable funding over one year). Both must be at least 100%.
Central banks: as lender of last resort, they lend to solvent banks against collateral when markets will not, as the Bank of England did, in a different form, in 2022.
Insurers: Solvency II has no LCR, but insurers must manage liquidity risk, and the 2022 LDI episode pushed supervisors to look harder at collateral calls on derivatives.

How the LCR and NSFR are calculated is in M4.5: Liquidity and IRRBB regulation.

Sparks

SparkQueues outside Northern Rock

In September 2007 news broke that Northern Rock, a UK mortgage lender that relied heavily on wholesale funding, had asked the Bank of England for emergency support. Savers queued outside its branches to take their money out: the first run on a British bank in well over a century. It was nationalised in February 2008.

SparkLiquidity is a coward

A market saying: liquidity is there when you do not need it and gone when you do. In March 2020, at the start of the pandemic, even US Treasuries, the deepest bond market in the world, became hard to trade for a few days as investors rushed for cash, until the Federal Reserve stepped in.

Key takeaways

Funding liquidity risk: not being able to pay what is due. Market liquidity risk: not being able to sell near the market price.
Each feeds the other: forced sales push prices down, lower prices cut funding, and more sales follow. That is a liquidity spiral.
Raising C in a fire sale at discount d means selling C ÷ (1 − d) of assets.
A survival horizon is the buffer after haircuts divided by daily net outflows.
A solvent firm can still fail if cash leaves faster than it can raise it; buffers, repo and central banks buy time.

Reaction

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Glossary

Funding liquidity risk: The risk that a firm cannot meet its payments and collateral calls as they fall due, expected or not, without hurting its daily business or its financial health.
Market liquidity risk: The risk that a firm cannot sell or hedge a position quickly at close to its market price, because the market is too thin or disrupted.
Liquidity buffer: Cash and assets that can be turned into cash quickly and reliably, even in a stress, held to meet outflows.
Fire sale: Selling assets quickly at a depressed price because you must, not because you want to.
Haircut: The cut a lender applies to collateral's market value when deciding how much cash to lend against it.
Margin call: A demand for more cash or collateral because a position or collateral has lost value.
Liquidity spiral: A loop in which falling prices force leveraged holders to sell, the sales push prices down further, and lenders demand more collateral.
Survival horizon: How long a firm could keep paying its outflows in a stress from its liquidity buffer alone.
LCR: Liquidity coverage ratio: high-quality liquid assets divided by net cash outflows over a 30-day stress. Must be at least 100%.
NSFR: Net stable funding ratio: stable funding available divided by stable funding required over one year. Must be at least 100%.
Lender of last resort: The central bank's role of lending to solvent banks against good collateral when markets will not.

Deep Dives & Origins

Deep Dives

Bank of England, Financial Stability Report, December 2022, on the LDI episode. Beginner.
Brunnermeier, “Deciphering the Liquidity and Credit Crunch 2007–2008”, Journal of Economic Perspectives 23(1), 2009. Intermediate.
Brunnermeier and Pedersen, “Market Liquidity and Funding Liquidity”, Review of Financial Studies 22(6), 2009. Advanced.

Origins

BCBS, Principles for Sound Liquidity Risk Management and Supervision, September 2008.
BCBS, Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, January 2013.
BCBS, Basel III: the net stable funding ratio, October 2014.
Bank of England, market notices on the temporary purchase of long-dated gilts, 28 September 2022.
House of Commons Treasury Committee, The run on the Rock, January 2008.

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