Understanding liquidity risk

Liquidity risk and other financial risks go together. For example, market risk is the possibility of losses due to fluctuations in interest rates, commodities, stocks and currencies. Managing market risk calls for ongoing adjustments of the exposure depending on the performance of the portfolio. But this adjustment is possible only when a liquid market exists where assets can be bought and sold easily.

Liquidity risk emanates from the liability side when creditors or investors demand their money back. This usually happens after the institution has incurred or is thought to have incurred losses that could threaten its solvency. Problems arise on the asset side when the forced liquidation of assets at distress prices causes substantial losses.

Liquidity risk is more complex than we think. Understanding liquidity risk involves knowledge of market microstructure, which is the study of market clearing mechanisms; optimal trade execution (e.g., minimising trading costs) and asset liability management (matching the values of assets and liabilities on the balance sheet).

Liquidity is crucially dependent on the market conditions and the prevailing sentiments. As Paul McCulley of the CFA Institute ( CFA Institute Reading 53, “The Liquidity Conundrum.”) mentions, “Liquidity is the result of the appetite of investors to underwrite risk and the appetite of savers to provide leverage to investors who want to underwrite risk. The greater the risk appetite, the greater the liquidity and vice versa. Put another way, liquidity is the joining or separating of two states of mind – a leveraged investor who want to underwrite risk and an unleveraged saver who does not want to take risk and who is the source of liquidity to the leveraged investor. The alignment or misalignment of the two investors determines the abundance or shortage of liquidity.”

In his very insightful book, “The Partnership,” consultant Charles Ellis has given an excellent example of liquidity by quoting Bob Mnuchin, a senior leader of Goldman Sachs: “When you can get out a stock that you’re long at a small loss and buy back a stock you’re short at a small loss, that’s an easy decision. It is painful when there isn’t an apparent opportunity to unwind a position or the price moves farther and faster away. Then you hesitate. Then you pray.”