Funding liquidity and market liquidity · RiskAtoms Academy

By the end you will be able to

1Tell funding liquidity from market liquidity on a bank's balance sheet, and say which side of the balance sheet each lives on.
2Turn a buffer into cash: counterbalancing capacity, forced-sale discounts and the cost of selling into a falling market.
3Trace the spiral (forced sales, falling prices, higher haircuts, margin calls) through a bank's numbers, and measure how fast market stress eats headroom.
4Find your way around the Module 3.5 liquidity book and its headline figures.

Why it matters

On 8 March 2023 Silicon Valley Bank said it had sold $21 billion of securities to raise cash, booking a $1.8 billion loss after tax. The sale was meant to steady its funding. Instead it showed depositors what its bond portfolio was worth if sold, and the next day they withdrew over $40 billion. The bank failed on 10 March. Funding liquidity and market liquidity are two different questions, but in a crisis each one answers the other.

Core explanation

Two kinds of liquidity, one balance sheet

L2.2.04: Liquidity risk drew the line between the two, and L3.2.17: Market liquidity risk priced market liquidity for a trading desk. This module is about a whole bank, day to day. Recall the definitions in one line each:

Funding liquidity: can we pay?

Funding liquidity lives on the liability side and in the off-balance-sheet commitments: deposits that can be withdrawn, wholesale funding that must be renewed, credit lines customers can draw, collateral the bank may have to post. Its question is timing: what falls due, and when.

Market liquidity: at what price?

Market liquidity lives on the asset side: how much cash the bank can raise from what it owns, how fast, and at what discount, by selling it or pledging it in repo or at the central bank. Its question is price.

They meet in one number. A bank survives a stress as long as the cash that has left, net of what has come in, stays below the cash it can raise from its assets. The first is the cumulative net outflow (funding liquidity); the second is the counterbalancing capacity, which depends on prices and haircuts (market liquidity). The gap between them is the bank's headroom.

Meet the liquidity book

Illustrative dataRiskAtoms Bank plc's liquidity book

A made-up UK bank's £67bn balance sheet on one made-up reporting date, in pounds, seen through its cash flows: every line's contractual maturity in ten buckets from overnight to over five years, its undrawn commitments and collateral triggers, and a 90-day stress test. The figures are round illustrative values, not any bank's data. The same book runs through every lesson in Module 3.5, so the figures agree.

Principal flows only: interest payments are left out throughout the module.

RiskAtoms Bank plc, the group's bank, has £16.0bn of cash and securities behind a £45.5bn loan book, funded mainly by £48.5bn of customer deposits. The tables show every line, and how much of it falls due within 30 days on contract.

Assets, £bn. Level 1, 2A and 2B mark the high-quality liquid assets (HQLA) that make up the buffer.
Asset	Amount	Share	Due in 30 days
Cash and central bank reservesLevel 1	£6.0bn	9.0%	buffer
UK government bonds (gilts)Level 1, £1.5bn pledged	£7.0bn	10.4%	buffer
Covered bonds and AA corporate bonds (Level 2A)Level 2A	£2.0bn	3.0%	buffer
BBB corporate bonds and listed shares (Level 2B)Level 2B	£1.0bn	1.5%	buffer
Reverse repos with banks, secured on gilts	£3.0bn	4.5%	£2.6bn
Unsecured placements with banks	£1.5bn	2.2%	£1.0bn
Residential mortgages£5.0bn pledged	£30.0bn	44.8%	£0.1bn
Loans to companies	£12.0bn	17.9%	£0.5bn
Personal loans and credit cards	£3.5bn	5.2%	£0.1bn
Other assets (premises, intangibles, derivatives)	£1.0bn	1.5%	£0.0bn
Total assets	£67.0bn	100.0%	£4.3bn

Funding, £bn. Deposits with no fixed term fall due overnight on contract.
Liability or equity	Amount	Share	Due in 30 days
Stable retail deposits (insured current accounts)	£22.0bn	32.8%	£22.0bn
Less stable retail deposits (instant-access savings)	£10.0bn	14.9%	£10.0bn
Retail fixed-term deposits	£6.0bn	9.0%	£0.3bn
Operational deposits from companies (payments and cash management)	£5.0bn	7.5%	£5.0bn
Other corporate deposits	£5.5bn	8.2%	£4.2bn
Deposits from banks and other financial institutions	£3.0bn	4.5%	£2.4bn
Repo funding secured on gilts	£1.5bn	2.2%	£1.5bn
Commercial paper and certificates of deposit	£2.0bn	3.0%	£0.7bn
Senior unsecured bonds	£4.0bn	6.0%	£0.0bn
Covered bonds issued	£2.5bn	3.7%	£0.0bn
Central bank term funding	£1.0bn	1.5%	£0.0bn
Subordinated debt (Tier 2)	£0.5bn	0.7%	£0.0bn
Shareholders' equity	£4.0bn	6.0%	–
Total funding	£67.0bn	100.0%	£46.1bn

Two things stand out. First, £37.0bn of deposits have no fixed term, so on contract they could all be withdrawn tomorrow. Second, the buffer is mostly cash and gilts. Of the £16.0bn of cash and high-quality securities, £1.5bn of gilts are pledged in repo and so encumbered; the £14.5bn left counts as the buffer, worth £13.7bn after the regulatory haircuts on its high-quality liquid assets.

The book's headline figures, and the lesson that builds each one
Figure	Value
Liquidity buffer (HQLA after haircuts)L3.5.06: The liquidity buffer	£13.7bn
Contractual gap, overnightL3.5.04: Cash flow ladders and maturity gaps	−£40.8bn
Survival in the combined stressL3.5.05: Liquidity stress tests and survival horizons	47 days
Name-specific stress: spare at day 90L3.5.05: Liquidity stress tests and survival horizons	£0.9bn
Liquidity coverage ratio (LCR)L3.5.07: LCR and NSFR in practice	157.4%
Net stable funding ratio (NSFR)L3.5.07: LCR and NSFR in practice	146.7%

The spiral, on a bank's numbers

In calm markets the two kinds of liquidity are independent: a bank with outflows sells gilts at the screen price, and a bank with an illiquid bond simply waits. In a stress they lock together. Click through the loop with the book's figures from its combined stress, a name-specific run and a market-wide freeze at once.

ExploreOne turn of the liquidity spiral at RiskAtoms Bank

Click a box to see what happens there.

Funding shock

In the first month of the combined stress, £7.2bn of deposits are withdrawn and £3.1bn of maturing wholesale funding is not renewed. After facility drawdowns, the downgrade call and the inflows that still arrive, the bank must find £12.4bn.

The spiral is why the book's buffer is mostly cash and gilts. The assets that matter in a crisis are the ones whose price holds up when everyone is selling. Liquidity that exists only in calm markets is not a buffer.

Which liquidity broke first? Guess, then open each card.

The formal version

Where the two liquidities meet

Let $O_s$ and $I_s$ be the stressed outflows and inflows on day $s$ , and let the buffer hold assets $a$ with face value $V_a$ and forced-sale discount (or repo haircut) $h_a$ . Then

\begin{aligned} N(t) &= \textstyle\sum_{s=1}^{t} \left(O_s - I_s\right) && \text{cumulative net outflow (funding)} \\ \text{CBC} &= \textstyle\sum_a V_a\,(1 - h_a) && \text{counterbalancing capacity (market)} \\ H(t) &= \text{CBC} - N(t) && \text{headroom: the bank can pay while } H(t) \ge 0 \end{aligned}

Now let market stress $m$ scale both sides, as in the book: each discount is $h_a\,m$ , and collateral calls add $C\,m$ to the outflow. Headroom then falls in a straight line:

\begin{aligned} H(m) &= \sum_a V_a\,(1 - h_a m) - \bigl(N_0 + C\,m\bigr) \\ &= \underbrace{\Bigl(\sum_a V_a - N_0\Bigr)}_{\text{headroom in a calm market}} - \;m\,\Bigl(\underbrace{\sum_a V_a h_a}_{\text{prices}} + \underbrace{C}_{\text{calls}}\Bigr) \\ \frac{dH}{dm} &= -\Bigl(\text{£}5.5\text{bn} \times 2\% + \text{£}2.0\text{bn} \times 10\% + \text{£}1.0\text{bn} \times 30\% + \text{£}300\text{m}\Bigr) \\ &= -\bigl(\text{£}610\text{m} + \text{£}300\text{m}\bigr) = -\text{£}910\text{m} \end{aligned}

Cash carries no discount, so it drops out of the slope. Each unit of market stress costs the book £0.91bn of headroom: £0.61bn through prices and £0.30bn through calls. The line is a simplification: a real spiral bends downwards, because the bank's own sales push its discounts wider still.

Try it

Set a month's funding outflow and a level of market stress. The bank pays from cash first, then sells gilts, then Level 2A and Level 2B bonds at the discounts the stress implies. Push the stress up with the outflow fixed and watch both bars move: the buffer shrinks and the bill grows.

Try itA funding outflow meets a stressed market

Funding outflow over 30 days, net of inflows£12.4bn

Market stress (1 = the book's market-wide scenario)× 1.0

Discounts on a forced sale at this stress: gilts 2.0%, Level 2A 10.0%, Level 2B 30.0%. Collateral calls: £300m.

Cash used£6,000m
Gilts sold (face)£5,500m
Level 2A sold (face)£1,406m
Level 2B sold (face)£0m
Buffer left at sale prices£1,235m

Cash needed (outflow + calls)£12,655m

Headroom at day 30£1,235m

Buffer at forced-sale prices£13,890m

Lost to discounts on what was sold£251m

Buffer at face value£14,500m

Securities sold (face)£6,906m

Illustrative. The buffer is the book's unencumbered cash and securities: £6.0bn of cash and reserves, £5.5bn of gilts, £2.0bn of Level 2A and £1.0bn of Level 2B. Cash is spent first, then the most liquid securities. Selling and repo raise about the same cash here; repo keeps the bonds but ties them up.

Headroom at day 30 by funding outflow and market stress (the Try it's model)
Funding outflow	Stress × 0	Stress × 1	Stress × 2	Stress × 3
£6bn	£8.50bn	£7.59bn	£6.68bn	£5.77bn
£8bn	£6.50bn	£5.59bn	£4.68bn	£3.77bn
£10bn	£4.50bn	£3.59bn	£2.68bn	£1.77bn
£12bn	£2.50bn	£1.59bn	£0.68bn	−£0.23bn
£14bn	£0.50bn	−£0.41bn	−£1.32bn	−£2.23bn

Read the table along a row: a £12bn outflow is comfortable in a calm market and fatal at three times the market-wide stress. Neither shock alone breaks the bank; together they do.

Worked example

The combined stress's first month

The book's combined scenario (a three-notch downgrade of RiskAtoms Bank during a market-wide freeze) runs for 90 days in L3.5.05: Liquidity stress tests and survival horizons. Here is its first month, split into the funding side and the market side. Figures in £m from the book.

From outflows to headroom

Step 1 of 6

1
The funding side
$\begin{aligned} \text{outflows} &= \text{£}16{,}630\text{m} \quad\text{(deposits, wholesale, facilities, downgrade, calls)} \\ \text{inflows} &= \text{£}3{,}975\text{m} \\ N(30) &= \text{£}16{,}630\text{m} - \text{£}3{,}975\text{m} = \text{£}12{,}655\text{m} \end{aligned}$

What the split says

For this bank the funding side dominates: £12.4bn of outflows against £0.91bn per unit of market stress. That is a design choice. If its £8.5bn of securities were all Level 2B bonds, they would lose 30% of their value per unit of stress, not the 7.2% the book's mix of mostly gilts loses.

Regulatory lens

The Basel Committee's Principles for Sound Liquidity Risk Management and Supervision (2008) define both risks: funding liquidity risk as the risk that a firm cannot meet expected and unexpected cash flow and collateral needs efficiently, and market liquidity risk as the risk that it cannot easily offset or eliminate a position at the market price because of inadequate market depth or disruption. The liquidity coverage ratio builds market liquidity into its buffer: Level 2A assets count at 85% of their value and Level 2B at 50% to 75%, and only unencumbered assets count. How the LCR and NSFR are calculated is in M4.5: Liquidity and IRRBB regulation; how banks model stressed cash flows and behaviour is in M6.7: Liquidity, ALM and behavioural models.

Spark Atoms

Spark AtomA haircut of 100%

Gorton and Metrick tracked repo haircuts through 2007 and 2008. Their index rose from zero in early 2007 to nearly 50% at the peak of the crisis, and some kinds of collateral stopped being accepted at all. They called that what it is: a haircut of 100%. A bond nobody will lend against is, for funding, worth nothing.

Spark AtomThe sale that started the run

Silicon Valley Bank sold $21 billion of securities to raise cash and reposition its balance sheet. The $1.8 billion after-tax loss it booked was already there in its bond prices; selling made it real and public. The Federal Reserve's review says that, by the end of the next day, depositors had withdrawn over $40 billion and management expected over $100 billion more.

Key takeaways

Funding liquidity (can we pay?) lives on the liability side and in commitments; market liquidity (at what price?) lives on the asset side.
They meet in headroom: counterbalancing capacity, the cash the buffer raises after discounts and haircuts, less the cumulative net outflow.
The spiral: forced sales push prices down, haircuts rise, margin calls arrive, and more sales follow.
On the book, each unit of market stress costs £0.91bn of headroom: £0.61bn through prices and £0.30bn through calls.
In the combined stress's first month, the bank pays out £12,655m net and keeps £1,235m of headroom, £910m less than in a calm market.
A buffer must hold its value when everyone sells, which is why RiskAtoms Bank's is mostly cash, reserves and gilts.

Reaction

Check what stuck

Glossary

Funding liquidity: Funding liquidity: the ability to meet expected and unexpected cash flows and collateral calls as they fall due, without disrupting daily business or the firm's financial condition.
Market liquidity: Market liquidity: the ability to sell or pledge an asset quickly, in size, close to its market price. Measured by bid-ask spreads, market depth and price impact.
Counterbalancing capacity: Counterbalancing capacity: the cash a firm can raise from its assets in a stress, by selling them or borrowing against them, after discounts and haircuts.
Cumulative net outflow: Cumulative net outflow: everything that has left (deposits withdrawn, funding not renewed, facilities drawn, collateral posted) less everything that has come in, from the start of the stress to a given day.
Headroom: Headroom: counterbalancing capacity less the cumulative net outflow. Below zero, the firm cannot pay.
Haircut: Haircut: the share of an asset's value a lender will not lend against, or the discount a forced seller accepts.
Forced sale: Forced sale (fire sale): selling assets because cash is needed now, at whatever price buyers will pay.
High-quality liquid assets (HQLA): High-quality liquid assets (HQLA): cash, central bank reserves and securities that stay easy to sell or pledge in a stress. Level 1 counts in full; Level 2A and 2B carry haircuts.
Encumbered asset: Encumbered: pledged as collateral elsewhere, so not available to raise new cash.
Liquidity spiral: Liquidity spiral: funding liquidity and market liquidity weakening each other. Forced sales push prices down, which raises haircuts and margin calls, which forces more sales.

Deep Dives & Origins

Deep Dives

M. K. Brunnermeier and L. H. Pedersen, “Market Liquidity and Funding Liquidity”, Review of Financial Studies, 22(6), 2009, pp. 2201–2238. Advanced.
Basel Committee on Banking Supervision, Principles for Sound Liquidity Risk Management and Supervision, BIS, September 2008. Intermediate.

Origins

Basel Committee on Banking Supervision, Principles for Sound Liquidity Risk Management and Supervision, BIS, 2008, paragraph 1 and footnote 2.
M. K. Brunnermeier and L. H. Pedersen, “Market Liquidity and Funding Liquidity”, Review of Financial Studies, 22(6), 2009, pp. 2201–2238.
G. Gorton and A. Metrick, “Securitized Banking and the Run on Repo”, working paper version of 6 June 2010 (Yale and NBER), published in the Journal of Financial Economics, 104(3), 2012, pp. 425–451.
H. S. Shin, “Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis”, Journal of Economic Perspectives, 23(1), 2009, pp. 101–119.
Board of Governors of the Federal Reserve System, Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, April 2023.

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