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Home > Financial Risk Management Best Practice > Managing Liquidity Risk in a Financial Institution: The Dangers of Short-Term Liabilities

Financial Risk Management Best Practice

Managing Liquidity Risk in a Financial Institution: The Dangers of Short-Term Liabilities

by David Shimko

Executive Summary

  • Organizations fail if they do not have access to sufficient cash to meet their short-term liabilities as they fall due.

  • As long as short-term assets exceed short-term liabilities, companies face minimal liquidity problems.

  • Fluctuations in margining requirements from lenders and trading counterparties can cause short-term liabilities to rise sharply, precisely when assets fall, leading to costly and sudden liquidations.

  • Collateral haircuts, discretionary interest rates, and material adverse change clauses exacerbate liquidity risk.

  • Ironically, lenders make “bank runs” on liquidity-stressed funds and corporations, each lender securing its own interest while collectively destroying value.

  • Enron’s demise was triggered by fraud, but caused by inability to manage liquidity risk.

  • Financial institution bankruptcies and restructurings in 2008 were accelerated by the inability or failure to manage liquidity risk.

  • Corporations must manage these risks through better contracting and precommitted contingency plans.

The Balance Sheet and Short-Term Liabilities

The assets and liabilities of a firm can be segregated into their short-term and long-term components. Short-term assets include cash, cash equivalents, marketable securities, and marketable inventories—i.e., any asset that can be converted in a short period of time to cash. Long-term assets include assets that cannot easily be converted to cash, such as plant and equipment, reputation, good will, and the present value of future growth opportunities. Short-term liabilities include short-term debt and liabilities which can be converted to debt, such as lender margin calls and trading counterparty collateral calls. Long-term liabilities include long-term debt and equity, or other long-term funding mechanisms. The basic schematic is shown in Figure 1.

As long as short-term assets exceed short-term liabilities, companies will not have many liquidity problems, finding resources or engaging in short-term borrowing to offset liabilities as they become due. A serious problem arises, however, when short-term assets or short-term liabilities are stochastic, or unpredictably variable. In these situations, its short-term liabilities can suddenly exceed short-term assets, forcing the company to liquidate long-term assets, increase long-term liabilities, or face bankruptcy. When these events take place, the company enters “financial distress,” and can find that the market for both its assets and liabilities has diminished or disappeared.

Contributors to Liquidity Risk

The term liquidity risk is meant to capture the risks to a corporation of having its short-term liability funding requirements unmet by its short-term assets. In essence, this is the risk that the company will not have sufficient cash to meet its liabilities as they fall due. Liquidity risk is also used to describe the risk of an increase in a security’s bid–offer spread or a reduction in market depth for a traded security. The two types of liquidity risk are related yet distinct. In this article, we focus on the first definition.

Liquidity risk arises from the variable components of short-term assets and liabilities. On the asset side, security values may fall. On the liability side, lenders may make margin calls on security loans, trading counterparties may make collateral calls on repurchase agreements and over-the-counter (OTC) derivative trades, and futures exchanges may make mark-to-market cash demands. In the case of a commercial bank, when depositors demand their funds, they are converting longer-term bank liabilities into shorter-term liabilities. In a classical “bank run,” the short-term liabilities exceed the available liquid assets of the bank, and the bank is forced into liquidating assets, restructuring, or going bankrupt.1

Therefore, liquidity risk includes the add-on losses experienced by banks and corporations as a result of failure to pay short-term liabilities. Most significantly, these losses include:

  • the discount accepted by the company for selling its assets in a “fire sale”;

  • the increased cost of funding liabilities in a financially distressed situation;

  • a reduction in the value of reputation, good will, and present value of future growth opportunities in the event of financial distress;

  • the loss of all intangible corporate assets in the event of a bankruptcy.

Example Using a Margin Loan

Suppose a fund has $100 to invest. It borrows $100 on a margin loan and invests $200 in securities with a 25% volatility factor. Within a month’s time, if the security moves downward by $23.74, or 11.9%,2 the fund will receive a margin call from its lender. At the time of the margin call, the fund can either liquidate assets or increase its equity by adding cash. If it liquidates assets, it must sell an amount equivalent to the drop in the market value of the securities to pay down the debt. Once this is done, the debt and equity are balanced, and the size of the fund is reduced. This can be seen in Table 1.

Table 1. Asset sale

ASSETS LIABILITIES 
EventSecuritiesCashLoanEquity
Before investment0.00100.000.00100.00
Initial investment200.000.00100.00100.00
Asset value falls176.260.00100.0076.26
After asset sales152.5123.74100.0076.26
Pay down loan152.510.0076.2676.26

If the fund addresses the margin call by bringing in additional funds equal to the drop in value of the securities, the accounts unfold as shown in Table 2. Even if the cash is used to pay down debt, the effect is not exactly the same as the first case, since the security position did not have to be liquidated in this case.

Table 2. Equity infusion

ASSETS LIABILITIES 
EventSecuritiesCashLoanEquity
Before investment0.00100.000.00100.00
Initial investment200.000.00100.00100.00
Asset value falls176.260.00100.0076.26
Call equity    
investment6.2623.74100.00100.00

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Further reading

Books:

  • Banks, Erik. Liquidity Risk: Managing Asset and Funding Risks. Finance and Capital Markets Series. Basingstoke, UK: Palgrave Macmillan, 2005.
  • Matz, Leonard, and Peter Neu (eds). Liquidity Risk Measurement and Management: A Practitioner’s Guide to Global Best Practices. Singapore: Wiley, 2007.
  • Persaud, Avinash D. (ed). Liquidity Black Holes: Understanding, Quantifying and Managing Financial Liquidity Risk. London: Risk Books, 2003.
  • Tirole, Jean. Financial Crises, Liquidity, and the International Monetary System. Princeton, NJ: Princeton University Press, 2002.

Report:

  • Basel Committee on Banking Supervision. “Liquidity risk: Management and supervisory challenges.” Bank for International Settlements, February 2008. Online at: www.bis.org/publ/bcbs136.htm

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