Liquidity Risks - Market Liquidity, Funding Liquidity, and Central Bank Liquidity - Essay Example

Liquidity Risk Name College Course Tutor Date Introduction In finance, there are risks that cannot be evaded in the financial system. These risks are categorized accordingly. A few examples of these risks are: - Credit risk - Refinancing risk - Concentration risk - Operational risk - Market risk - Country risk - Interest rate risk - Commodity risk - Liquidity risk - Legal risk - Model risk - Valuation risk - Currency risk - Systemic risk - Reputational risk - Political risk - Equity risk - Profit risk - Volatility risk - Political risk - Settlement risk Our main focus will be on liquidity risk and what pertains to liquidity risk. Before we look at that, we have to understand liquidity a bit so as to move on. Do you know how much easily accessible money you have in the form of cash? This is a measure of your liquidity. As you'll see, this concept plays a role in your financial and investing lives and those of the companies you buy and sell. Starting from a definition of liquidity and liquidity risks with examples of different types, we'll move on to a discussion of the advantages and disadvantages of liquidity, its pricing and measures and finally how it works and why it matters Definition Liquidity can be defined as how an asset can be converted to something else quickly and easily. It is measured on how often a product is bought and sold. A very good example of a highly liquidity product is gold because it has high demand and hence one can easily get market for it. Cash is extremely liquid because people can readily accept it as payment for just about anything. It can be “sold” for goods and services instantly without loss of value and one does not have to wait for so long to get a suitable buyer.it has been universally accepted and largely adapted in almost all countries worldwide and hence easily traded for anything in the market as it is a universal channel of trade in transactions and businesses. When a company or a bank in financial markets cannot sell investment/convert assets and security quickly enough to prevent loss of income or capital is known as liquidity risk. It happens when the asset cannot be traded quickly enough in a market to prevent required profit (loss). Constant rise in liquidity risk causes a widened bid-offer spreads because investors will opt to sell their investments at any price. This causes market illiquidity or decreased ability to trade profitably. There are three types of liquidity (risks), namely: market liquidity, funding liquidity and central bank liquidity I. Market liquidity This first one is relates to the ability to trade in the market. It’s the ability of a market to trade a hard asset at short notice without incurring a heavy loss by not changing its price or impacting it slightly. It’s therefore obvious to judge market liquidity on several grounds while the most obvious one is the ability to trade. It occurs where a market cannot facilitate the purchase of an asset or security. This can be because of the following reasons: Widening bid spread Making precise liquidity reserves There are two types of market liquidity. The liquidity in the interbank market. This is where banks inter-trade liquidity amongst themselves and the liquidity in the asset market, where assets are being traded among financial agents. These two types, as will be seen, are the main sources for a bank to acquire funding liquidity from the markets and therefore can help us explain interactions between the various liquidity types. Market liquidity risk is the loss incurred by a market participant when he/she tries to make a trade or rather tries to liquidate an asset but they do not hit the price they wanted. II. Funding liquidity This second one, relates to the as the ability of banks to meet their liabilities, fund, unwind or settle their positions as they come due. Similarly, the IMF provides a definition of funding liquidity as the ability of solvent institutions to make agree upon payments in a timely fashion From the word fund, we literally extract our meaning i.e (funding= the act of financing).Funding liquidity occurs when a bank incurs losses when trying to fund or meet obligations of their assets. This may happen because a bank’s liability:- Cannot be met when they fall due Can only be met at a price that is not economical Can be specifically named or systemic However, also references have been made to funding liquidity from the point of view of traders by Brunnermeier M. &Pedersen (2007) or investor Strahan, as where funding liquidity relates to their ability to raise funding (capital or cash) in short notice. Since our focus is mainly on funding liquidity by banks we should see the sources of bank liquidity since it is useful i.e. as seen earlier its paramount importance is to provide liquidity to the financial system. One source is the depositor who entrusts their money to a bank. A second is the market. According to Strahan(2008) a bank can always go to the asset market and sell its assets or generate liquidity through loan syndication, securitization and the secondary market for loans, in its role as distributor and originator. Moreover, the bank can get liquidity from the interbank market1, arguably the most important source of liquidity. Lastly, a bank can also choose to get funding liquidity directly from the central bank. Funding liquidity risk is the risk that a bank is not able to meet the cash flow and collateral need obligations III. Central bank liquidity This one is concerned with the liquidity provided by the central bank. It’s the ability that the central bank can provide the liquidity needed to the financial system These three types of liquidity are interdepend Figure 1: The three liquidity nodes of the financial system What could cause liquidity risk? Liquidity risks could be caused by factors such as; -the asset does not get potential persons to trade for it. This can be seen when the price of the asset begins to drop and eventually becomes zero. When an asset’s price is zero that means that the asset has lost market and is worthless. -the asset has a potential trader but the two persons don’t have a platform where they can meet and hence have a transaction. -it could be caused when an institution experiences unexpected cash outflow from the institution due to sudden factors/situation, when its trading partner due to its reasons like disagreements or discontentment decide to stop trading with them/lending the institution or when their dependent markets lose liquidity of their products As seen earlier, financial liquidity is when you have your money at hand or have investments that can be easily converted to cash. More cash either at hand or in accounts dictates to high financial liquidity. There are advantages and disadvantages of liquidity as explained below: ADVANTAGES OF LIQUIDITY Though liquid holdings rarely earn anything but low interest rates, they typically make up for it by maintaining a concrete value and accessibility. This is its main advantage. Other advantages include Lower risk of loss We live in a world that is full of uncertainty and tragedies such as floods, wars, earthquakes and such like. In the event of such occurrences, liquid assets are safe. In case of a house fire outbreak for instance, one’s money is safe in the bank as opposed to being in the house. Quick access Quick access to one’s money is a very important advantage of liquid cash because we can fund for the day to day bills e.g. transport, food and also we can easily pay for unexpected debts. It also guarantees high and immediate access to ones savings in case of an emergency.one can also borrow loans and get them almost instantly and rescue a situation that urgently needed cash Limited returns Those who wish to get added interest to the secured liquid cash may opt to buying market funds, shares and bonds but will have to sell them later on in order to get their gain in cash. DISADVANTAGES OF LIQUIDITY In a challenging economy which is vastly common, many struggle with too little liquidity. For example, many have their primary asset as their home, which is financed for more than it is worth. Nevertheless, significant disadvantages come with being with too liquid -- whether you own a business or just want to balance your checkbook. Some of these disadvantages are: Interest rates There is always little or no interests on liquidity. Compare having your cash at hand to having cash in the bank or a financial institution. Investors at the bank will be exposed to your money thus investing it, it will earn more and pay you in return Inflation When a nation’s economy is inflated, its money has a lower purchasing power. If you "own" money, or you are liquid, at a low price and the cost of goods jumps dramatically, your cash is worth less than it was when you acquired it. If you try investing in a product, it can act as a hedge to inflation since its value is not trapped at the lower value. Taxes One has to pay taxes on minimal amount of interest they receive on investments. Paying taxes in addition to increasing inflation means you lose money on these low-interest liquid investments. If you put your liquidity into an IRA, you can claim tax deduction often and reduce your tax bill, this also applies to small businesses. Other considerations Liquidity is often sited to peace of mind.in a business, too much liquidity indicate you are spending little on developing the business.no new revenue streams means you’ll likely lose market share if your existing revenue falls due to normal demand curves and product life cycle. Pricing of liquidity risk Investors who are strongly opposed to risk naturally require higher expected return as compensation for liquidity risk. The liquidity-adjusted CAPM pricing model therefore states that, the higher an asset’s market-liquidity risk, the higher its required return. Measures of liquidity risk Liquidity gap Culp gives a definition of liquidity gap as the net liquid assets of a firm. The excess value of the firm's liquid assets over its liabilities that are volatile. A company that has a negative liquidity gap should focus on their cash balances and the possible unexpected changes in their values. As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm's marginal funding cost. Liquidity risk elasticity Culp also denotes the change of net of assets over funded liabilities that occurs when the liquidity premium on the bank's marginal funding cost rises by a no/small amount as the liquidity risk elasticity. For banks, this would be measured as a spread over interest rate on loans between banks, for non-financials, the liquidity risk elasticity would be measured as a spread over commercial paper rates. Problems with the use of liquidity risk elasticity are that it is only accurate for small changes in funding spreads and that it assumes parallel changes in funding spread across all maturities. HOW IT WORKS/EXAMPLE Liquidity risk generally occurs when an individual or company with urgent cash needs cannot be able to meet those needs despite having an asset/ investment. Their assets however cannot find someone to trade it despite their high value in the market. This difficulty in finding someone to buy their asset forces them to sell it at a lower price than they intended it to be so as to get someone to purchase it and hence be able to settle their needs. For example, let’s consider Kenny who owns a $1,000,000 home. Kenny due to his urgent financial needs of paying his medical bill decides on selling his home. There are however no one to buy the home because of its then market conditions despite its value and perfect look. In better economic times though the home would have gone for even a higher price but because Kenny’s needs are very urgent he has no option but to sell the home at a significant loss. Hence, the liquidity risk of holding on Kenny’s asset. Why it matters The importance of liquidity assets is that they can be purchased or sold without compromising their value. As seen earlier, liquid assets are those that can easily be converted to cash in a short period of time, giving the owner of the asset greater financial freedom In times of crisis, having liquid assets are important since they can be converted easily to cash. Without liquidity, money can become tied up in systems that are difficult to cash out of and even more difficult to assess for actual cash value. Making matters worse, during times of emergency, large financial institutions may shut down, making people with their cash there not access them thus preventing or making it difficult for them to buy essentials like food, gasoline and other emergency supplies. Liquidity is also used to determine the financial health of a business or personal investment portfolio. Three liquidity ratios used for this purpose are: current ratio, the quick ratio and the capital ratio. Liquidity not only helps ensure that a person or business always has a reliable supply of cash close at hand, but it is a powerful tool when it comes to determining the financial health of future investments as well. Conclusion Liquidity is as how an asset can be converted to something else quickly and easily. It is measured on how often a product is bought and sold Liquidity risk is the risk that arises from difficulty of selling an asset. Liquidity risk generally occurs when an individual or company with urgent cash needs cannot be able to meet those needs despite having an asset/ investment The cause of liquidity risk lies in the coordination failures among banks, their depositors and traders in the market The three main liquidity types are: funding liquidity, market liquidity and central bank liquidity. These types depend on each other In turbulent times, the linkages between these three types’ remains but serves as risk propagation channels and can destabilize the financial system. The central bank liquidity policies can temporarily halt, but restructuring the system will show the source of the liquidity risk and restore the virtuous circle The advantages of liquidity are: lower risk of loss, quick access and limited returns while its disadvantages are: taxes, inflation, interest rates and other considerations Funding liquidity risk is the risk that a bank is not able to meet the cash flow and collateral need obligations Market liquidity risk is the loss incurred by a market participant when he/she tries to make a trade or rather tries to liquidate an asset but they do not hit the price they wanted. Funding liquidity tends to manifest as a credit risk i.e. inability to fund liabilities produces defaults. On the other hand, Market liquidity risk manifests as market risk: inability to sell an asset drives its market price down, or worse, renders the market price unclear. The higher an asset’s market-liquidity risk, the higher its required return References [1] BIS (1999), Market Liquidity: Research Findings and Selected Policy Implications. [2] BDF (2008), Special Issue Liquidity. Financial Stability Review, Bank of France, February. [3] Brunnermeier M. and L. H. Pedersen (2007), Market Liquidity and Funding Liquidity. The Review of Financial Studies, forthcoming. Read More