Identifying Liquidity Risk for Financial Stability

This whitepaper explores the importance of liquidity in the functioning of financial markets and the increasing regulatory pressures on capital market firms to ensure strong liquidity risk management practices are being carried out.

The global financial crisis highlighted the importance of liquidity in functioning financial markets. Pre-2008, market participants received easy access to readily available funding and were ill-prepared for events that transpired during the credit crisis. Failure to adequately assess and manage liquidity underpinned major market turmoil, triggering unprecedented liquidity events and the ultimate demise of Bear Stearns, Lehman Brothers and other financial institutions previously thought too big to fail.

The global financial crisis has promoted a renewed focus on managing liquidity risk. Lack of liquidity, in the midst of all the panic, left many firms unable to raise sufficient funding, forcing them to liquidate their positions at huge losses, further fuelling the fear of a systemic crisis. In an attempt to avert a meltdown of the banking system and deep global economic recession, central banks had little choice but to inject liquidity into the financial markets. Almost 10 years on, awareness of liquidity risk has become the norm and its management essential to the viability of financial institutions. Looking ahead, effective risk management strategies must address the major issues that compromised firms during the drawdown. Liquidity should not be viewed as a short-term operational issue, but as a central component of long-term business strategies.

As the credit crisis demonstrated, ignorance of liquidity risk is dangerous. Sourcing and transferring risk in the secondary market has, consequently, become difficult. This should be a concern to all market participants. Credible analysis of transaction liquidity and associated cost is difficult, but not impossible. New technologies offer a deeper understanding of liquidity drivers in the market and, in turn, can help improve market activity. Asset managers can and should prepare for future liquidity events, but preparation alone will not prevent extreme volatility of asset prices. Fixing the structural imbalance and fortification of market infrastructure is what is truly required.

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