By Chase Nerison
Liquidity is one of the relevant risks a financial institution must consider when making decisions. This was not always the case. Prior to the global financial crisis of 2007-09, most financial models omitted liquidity risk. Notably, this crisis included a run on the non-depository, shadow banking system. This system provides short-term financing, like the repo (repurchase agreement) market, that rapidly withdrew liquidity. When looking at financial problems where institutions did not accurately account for risks, the global financial crisis usually represents these problems and their consequences.
Before examining the specifics in the global financial crisis, liquidity risk is a term used to determine how an asset or security can be bought or sold in the market. There are two main factors of liquidity: time and value. An asset with high liquidity is able to be bought and sold quickly and at market value. Assets with lower liquidity may be forced to sell at fire sale prices and not receive accurate value. The two main types of liquidity risk are funding and market. Funding liquidity risk is its ability to fund its liabilities. This is why the current ratio of current assets to current liabilities is an important measure. Market liquidity risk is the ability or inability to exit a position. This is more common. Small positions in the S&P 500 are liquid, but private positions through private equity for example are very illiquid. Many FIs were making money on illiquid assets as one pays a premium for liquidity. It was not a problem until it became a very big one.
The biggest shock to the banking system since the 1930s, the global financial crisis reminded FIs about liquidity risk. Banks provide liquidity to depositors and creditors being ready to provide cash at all times. Traditionally, liquidity risk stemmed from the possibility of bank runs. This is when depositors lose faith in their ability to withdraw their money due to concerns about the bank’s financial situation or the possibility of others staging bank runs. In this case, liquidity risk was exposed from a range of lending and interbank financial commitments. This can be dangerous because of the off-balance sheet items such as undrawn loan commitments and margin calls in the derivatives market. These loan commitments can become risky for FIs if lots of borrowers draw on funds. Some companies saw a disruption in the debt markets and decided to draw funds from existing credit lines out of fear. This was the case with American Electric Power drawing $2 billion from JP Morgan Chase and Barclays. With many companies having undrawn loan commitments of high amounts, this can create a massive problem.
Many know the global financial crisis is associated with the housing bubble and mortgage-backed securities (MBS). Repos were often used to finance these risky assets, and in 2007, MBS could almost be fully funded with short-term borrowed funds in the repo market. As the market changed drastically by the end of 2008, approximately 55% of each dollar invested in these securities could be financed that way. This is where banks were tasked with an important decision. They could sell their positions and take a massive loss or they would need to find new, very expensive sources of credit to keep their positions.
Though commercial banks were hit hard by the collapse of the repo market, they could increase deposits to bridge the financing gap. Nonbank brokerage firms could not do this. Despite banks cutting bank new lending in the middle of 2007, loans held on bank balance sheets continued to increase until the end of 2008 due to the plethora of off-balance sheet loan commitments. Loan balances continued to rise for almost a year into the great recession reflecting this movement into credit lines or other guarantees as shown in the graph below.
To manage liquidity during the crisis, banks with the highest exposure to liquidity risk significantly increased their holdings of liquid assets and reduced new lending. Banks with MBS expanded their cash buffers as they were worried about their inability to finance securitized assets. Harming the borrowers, banks protected themselves by hoarding liquidity. Model simulations show there would have been no liquidity buildup if banks had low levels of liquidity risk exposure at the time of the crisis. The drop in credit production would have been much lower if banks were more liquid.
Luckily, the Federal Reserve assisted with providing cash to lower liquidity risk. This bail out was necessary. As the financial world learns from its mistakes, liquidity risk must play a factor in every financial institution’s decisions. Banks should be mindful of the liquidity of their assets and their off-balance sheet loan commitments. Being conscious of these factors should lower the overall risk of another financial crisis or at least its severity.
Works Cited
Harper, D. (2021, September 21). Understanding liquidity risk. Investopedia. Retrieved November 28, 2021, from https://www.investopedia.com/articles/trading/11/understanding-liquidity-risk.asp.
Strahan, P. (2012, May 14). Research, economic research, liquidity, liquidity risk, financial crisis, bank liquidity, Credit. Federal Reserve Bank of San Francisco. Retrieved November 28, 2021, from https://www.frbsf.org/economic-research/publications/economic-letter/2012/may/liquidity-risk-credit-financial-crisis/.
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