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LIQUIDITY RISK: FUNDING

Liquidity risk of a firm is the risk that the cost of funding becomes higher, up to the extreme case when raising funds becoming impossible.

Funding risk depends upon how risky the market perceives the issuer and its funding policy. An institution coming to the market with unexpected and frequent needs for funds sends a negative signal, which might restrict the willingness to lend to this institution. The cost of funds also depends on the bank's credit standing. If the perception of the credit standing deteriorates, funding becomes more costly. The credit rating of the firm influences the cost of funds, making it a critical factor for a bank. In addition, it drives the ability to do business with other financial institutions since many investors follow some minimum rating guidelines for investing and lending.

Banks are not supposed to depend on liquidity crunch and should hold assets as an alternate source of funds than the market. In order to fulfill this role, liquid assets should mature in the short-term because market prices of long-term assets are more volatile[1], and more exposed to loss under sale. Banks used to reveal the size of the liquidity asset buffer and how much time they could sustain market disruption. Actually, the size of liquidity buffers should be related to cash flows and liquidity commitments of banks, including off balance sheet commitments, to make such time estimates meaningful. This is a route that supervisory authorities are considering for monitoring system-wide liquidity[2]. Liquidity risk is also dependent on system-wide market disruptions, as the sub-prime crisis illustrates.

Extreme lack of liquidity results in failure. Extreme conditions are often the outcome of others risks, such as major market or credit losses. Important unexpected losses raise doubts with respect to the solvency of the organization and lenders refrain from further lending to the troubled institution. Massive withdrawals of funds by the public plus the closing of credit lines by others institutions are direct outcomes of such situations.

  • [1] Long-term interest-bearing assets are more sensitive to interest rate movements. See the duration concept used for capturing the sensitivity of the mark-to-market value of the balance sheet in the related chapter on "Economic Value" of the balance sheet. Duration is introduced in Chapter 15, Sensitivity.
  • [2] See Chapter 61.
 
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