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All classical adverse mechanisms are supposed to have limited magnitude because of risk regulations. Risk regulations address the main risks faced by financial players. Risk is defined as a combination of uncertainty and potential losses resulting from adverse scenarios. Major risks are subject to quantification imposed by Basel regulations.

Credit risk is the risk of losses due to borrowers' defaults or deterioration of credit standing. Market risk is the risk of losses due to adverse movements of the value of financial instruments (stocks, bonds, etc.) because of market movements for an horizon that depends on the required time to liquidate them, thereby avoiding further losses. Both risks are regulated in banks. Credit risk is now subject to Basel 2 rules. Market risk has been measured since the 1996-1997 Basel amendments for market risk either by capital charges allocated to each exposure, or the now common "value-at-risk" calculation[1]. Other risks are well defined and supervised, even though they do not require a capital charge.

Interest rate risk is the risk of losses due to adverse movements of interest rates, notably when cost of debt increases. Liquidity risk, or funding risk, refers to the availability of funds when needed. It is the risk of not being able to raise funds at a reasonable cost, and it culminates when a financial entity cannot raise additional funds, with the ultimate stage being bank failure.

Both risks are related to mismatch risk. Mismatch risk results from the maturity of assets being often longer than maturity of financing. Lending or investing long and borrowing short is a common practice because it allows financial institutions to tap the lower rates of the highly liquid short-term market and to benefit from longer rates when lending (when the turn structure of interest rates is upward sloping). Maturity mismatch creates liquidity risk when financial players roll over their short-term debts. It creates as well interest rate risk since the rollover of short-term debts is at prevailing rates, which might increase. Mismatch risk is a common practice even in depository institutions, which benefits from short-term funds and lends for longer maturities. Since mismatch risk was the source of the failure of the saving and loans institutions in the US, when short-term interest rates jumped up when the Chairman of the Federal Reserve in the US, Paul Volcker, decided to increase interest rates to double digit levels for fighting inflation in 1979, it is still surprising that mismatch risk is left to direct control by banks, and entails no capital charge.

Obviously, financial players are aware of such risks and they prepare themselves for market disruptions. A common way of isolating a bank from market disruptions is to hold very liquid assets. Liquid assets are the easiest to sell without risk of significant losses. Short maturity risk-free assets are less exposed to value variations when interest rates increase. High credit quality assets are always in demand at time of uncertainty, when "flights to quality" occur. Assets meeting those two basic requirements are Treasury bills. Holding such assets allows one to rely on sales of such assets to obtain liquidity when market conditions deteriorate. Banks hold a varying fraction of their total assets in highly liquid assets. How much depends on the bank's exposure to such market disruptions and the bank's policies. Regulations do not provide minimum amounts although regulators normally monitor the situations of banks. The drawback for banks is the low return of such liquid assets, which creates a trade-off between the cushion against market disruptions and profitability.

Market liquidity risk is a price risk and refers to the capability of selling traded instruments at a "fair price." Market liquidity is directly related to the volume of trading in capital markets. As long as trading exists with some volume, selling assets without disrupting price remains relatively easy. The recent period demonstrated that market liquidity can dry up just as funding liquidity did.

The absence of stringent regulations on liquidity risk is the "liquidity hole" in regulations, as well as it is in the theory of finance. It proved to be a major weakness that turned a downturn of capital markets into a major liquidity crisis for both the markets and the financial system.

A review of financial reports of banks in various countries, referring to the end of 2006, showed that banks were apparently prepared for such risks. They disclosed the volumes of liquid assets; the mismatch between assets and liability maturities; the measures of regulatory capital; the excess capital buffer over minimum requirement; how they performed their value -at-risk calculations for market risk; and up to the assessment of "economic capital" for credit risk, based on economic assessment rather than regulatory rules. Such disclosures testify of the prevailing confidence in their risk management practices before the crisis.

  • [1] See related Chapters 19 and 20 on market risk regulations.
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