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59-403: The municipal treasurer is typically responsible for liquidity risk management, cash management , issuing and repaying debt , and interest rate risk , and oversight of pension investment management . They also typically advise the municipal council and municipal manager, or their equivalents, on matters relating to municipal finance. They could also have oversight of other areas, such as

118-600: A lender of last resort (LLR), this might result in a moral hazard problem, with the private sector becoming lax and this may even exacerbate the problem. Many economists therefore assert that the LLR must only be employed in extreme cases and must be a discretion of the government rather than a rule. Some economists argue that financial liberalization and increased inflows of foreign capital, especially if short term, can aggravate illiquidity of banks and increase their vulnerability. In this context, 'International Illiquidity' refers to

177-417: A liquidity crisis is an acute shortage of liquidity . Liquidity may refer to market liquidity (the ease with which an asset can be converted into a liquid medium, e.g. cash), funding liquidity (the ease with which borrowers can obtain external funding), or accounting liquidity (the health of an institution's balance sheet measured in terms of its cash-like assets). Additionally, some economists define

236-466: A cash-flow crisis when economic shocks resulted in excessive mark-to-market losses and margin calls . The fund suffered from a combination of funding and asset liquidity issues. The asset liquidity issue arose from LTCM's failure to account for liquidity becoming more valuable, as it did following the crisis. Since much of its balance sheet was exposed to liquidity risk premium, its short positions would increase in price relative to its long positions. This

295-537: A certain limit. In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability, such as 95 percent of the time. The FDIC discuss liquidity risk management and write "Contingency funding plans should incorporate events that could rapidly affect an institution’s liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or

354-504: A day-to-day basis assuming that an important counterparty defaults. Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps: Because balance sheets differ so significantly from one organization to

413-437: A depositor will only withdraw when it is appropriate for him to do so under optimal risk-sharing. However, if agents panic, their incentives are distorted and in such an equilibrium, all depositors withdraw their deposits. Since liquidated assets are sold at a loss, therefore in this scenario, a bank will liquidate all its assets, even if not all depositors withdraw. Note that the underlying reason for withdrawals by depositors in

472-437: A firm. The excess value of the firm's liquid assets over its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and 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. Culp denotes the change of net of assets over funded liabilities that occurs when

531-417: A flight to liquidity occurred during the 1998 Russian financial crisis , when the price of Treasury bonds sharply rose relative to less liquid debt instruments. This resulted in widening of credit spreads and major losses at Long-Term Capital Management and many other hedge funds. There exists scope for government policy to alleviate a liquidity crunch, by absorbing less liquid assets and in turn providing

590-411: A liquidity crisis (elaborated below). One of the mechanisms, that can work to amplify the effects of a small negative shock to the economy, is the balance sheet mechanism . Under this mechanism, a negative shock in the financial market lowers asset prices and erodes the financial institution's capital, thus worsening its balance sheet. Consequently, two liquidity spirals come into effect, which amplify

649-502: A liquidity crisis. Market participants in need of cash find it hard to locate potential trading partners to sell their assets . This may result either due to limited market participation or because of a decrease in cash held by financial market participants . Thus asset holders may be forced to sell their assets at a price below the long term fundamental price. Borrowers typically face higher loan costs and collateral requirements, compared to periods of ample liquidity, and unsecured debt

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708-464: A market to be liquid if it can absorb "liquidity trades" (sale of securities by investors to meet sudden needs for cash) without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets. The above-mentioned forces mutually reinforce each other during

767-461: A measure called liquidity at risk . A country's liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturity—averaged over estimated distributions for relevant financial variables—in excess of

826-404: A party interested in trading an asset cannot do it because nobody in the market wants to trade for that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade. Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market

885-407: A period of time, i.e., resilience is the capacity to recover. Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk . It can be defined at VAR + ELC (Exogenous Liquidity Cost). The ELC is the worst expected half-spread at a particular confidence level. Another adjustment, introduced in the 1970s with a regulatory precursor to today's VAR measures, is to consider VAR over

944-457: A pivotal role in amplifying the effects of a drop in property prices. Many asset prices drop significantly during liquidity crises. Hence, asset prices are subject to liquidity risk and risk-averse investors naturally require higher expected return as compensation for this risk. The liquidity-adjusted CAPM pricing model therefore states that, the higher an asset's market-liquidity risk, the higher its required return. Liquidity crises such as

1003-419: A position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk

1062-706: A registered voter. With no training requirement, citizens may have a legitimate concern and may impose post-election training requirements once in office. Some US states offer but may not require, extensive training and certification programs, such as the Certified California Municipal Treasurer . Appointed municipal treasurers, not subject to residency requirements, are likely to be subject to competition and likely must have finance-related college degrees, prior investment experience, municipal department head experience and appropriate training and certifications. Liquidity risk Liquidity risk

1121-528: A situation in which a country's short-term financial obligations denominated in foreign/hard currency exceed the amount of foreign/hard currency that it can obtain on a short notice. Empirical evidence reveals that weak fundamentals alone cannot account for all foreign capital outflows, especially from emerging markets . Open economy extensions of the Diamond–Dybvig Model, where runs on domestic deposits interact with foreign creditor panics (depending on

1180-516: Is flight to liquidity as investors exit illiquid investments and turn to secondary markets in pursuit of cash–like or easily saleable assets. Empirical evidence points towards widening price differentials, during periods of liquidity shortage, among assets that are otherwise alike, but differ in terms of their asset market liquidity. For instance, there are often large liquidity premia (in some cases as much as 10–15%) in Treasury bond prices. An example of

1239-445: Is a financial risk that for a certain period of time a given financial asset , security or commodity cannot be traded quickly enough in the market without impacting the market price. Market liquidity – An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk. This can be accounted for by: Funding liquidity – Risk that liabilities: Liquidity risk arises from situations in which

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1298-401: Is compounding credit risk . A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example—the two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft debacle. Futures contracts were used to hedge an over-the-counter finance (OTC) obligation. It is debatable whether

1357-404: Is nearly impossible to obtain. Typically, during a liquidity crisis, the interbank lending market does not function smoothly either. Several mechanisms operating through the mutual reinforcement of asset market liquidity and funding liquidity can amplify the effects of a small negative shock to the economy and result in a lack of liquidity and eventually a full-blown financial crisis . One of

1416-429: Is one that entails suspension of convertibility when there are too many withdrawals. For instance, consider a contract which is identical to the pure demand deposit contract, except that it states that a depositor will not receive anything on a given date if he attempts to prematurely withdraw, after a certain fraction of the bank's total deposits have been withdrawn. Such a contract has a unique Nash equilibrium which

1475-405: Is only accurate for small changes in funding spreads. The bid–ask spread is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product's bid price can be used. The smaller the ratio the more liquid the asset is. This spread is composed of operational, administrative, and processing costs as well as the compensation required for

1534-574: Is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets. Liquidity risk is financial risk due to uncertain liquidity . An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to

1593-417: Is stable and achieves optimal risk sharing. Expost policy intervention: Some experts suggest that the central bank should provide downside insurance in the event of a liquidity crisis. This could take the form of direct provision of insurance to asset-holders against losses or a commitment to purchasing assets in the event that the asset price falls below a threshold. Such 'asset purchases' will help drive up

1652-540: The financial crisis of 2007–2008 and the LTCM crisis of 1998 also result in deviations from the Law of one price , meaning that almost identical securities trade at different prices. This happens when investors are financially constrained and liquidity spirals affect more securities that are difficult to borrow against. Hence, a security's margin requirement can affect its value. A phenomenon frequently observed during liquidity crises

1711-572: The financial innovation bandwagon, often before they can fully apprehend the risks associated with new financial assets. Unexpected behaviour of such new financial assets can lead to market participants disengaging from risks they don't understand and investing in more liquid or familiar assets. This can be described as the information amplification mechanism . In the subprime mortgage crisis , rapid endorsement and later abandonment of complicated structured finance products such as collateralized debt obligations , mortgage-backed securities , etc. played

1770-447: The liquidity premium on the bank's marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for nonfinancials the LRE would be measured as a spread over commercial paper rates. Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it

1829-489: The "loss spiral". At the same time, lending standards and margins tighten, leading to the "margin spiral". Both these effects cause the borrowers to engage in a fire sale , lowering prices and deteriorating external financing conditions. Apart from the "balance sheet mechanism" described above, the lending channel can also dry up for reasons exogenous to the borrower's credit worthiness . For instance, banks may become concerned about their future access to capital markets in

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1888-458: The Diamond–Dybvig model is a shift in expectations . Alternatively, a bank run may occur because bank's assets, which are liquid but risky, no longer cover the nominally fixed liability (demand deposits), and depositors therefore withdraw quickly to minimize their potential losses. The model also provides a suitable framework for analysis of devices that can be used to contain and even prevent

1947-456: The bank failing. This can lead to failure of even 'healthy' banks and eventually an economy-wide contraction of liquidity, resulting in a full blown financial crisis. Diamond and Dybvig demonstrate that when banks provide pure demand deposit contracts, we can actually have multiple equilibria. If confidence is maintained, such contracts can actually improve on the competitive market outcome and provide better risk sharing. In such an equilibrium,

2006-425: The banks of advanced economies, which typically have a number of potential investors in the world capital markets, informational frictions imply that investors in emerging markets are 'fair weather friends'. Thus self – fulfilling panics akin to those observed during a bank run, are much more likely for these economies. Moreover, policy distortions in these countries work to magnify the effects of adverse shocks. Given

2065-485: The chances that the resources will be there when needed." Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk.: Amaranth Advisors lost roughly $ 6bn in the natural gas futures market in September 2006. Amaranth had taken a concentrated, leveraged, and undiversified position in its natural gas strategy. Amaranth's positions were staggeringly large, representing around 10% of

2124-421: The credit supply through such lending facilities with low margin requirements is an important second monetary tool (in addition to the interest rate tool), which can raise asset prices, lower bond yields, and ease the funding problems in the financial system during crises. While there are such benefits of intervention, there is also costs. It is argued by many economists that if the central bank declares itself as

2183-414: The demand and consequently the price of the asset in question, thereby easing the liquidity shortage faced by borrowers. Alternatively, the government could provide 'deposit insurance', where it guarantees that a promised return will be paid to all those who withdraw. In the framework of the Diamond–Dybvig model, demand deposit contracts with government deposit insurance help achieve the optimal equilibrium if

2242-401: The earliest and most influential models of liquidity crisis and bank runs was given by Diamond and Dybvig in 1983. The Diamond–Dybvig model demonstrates how financial intermediation by banks, performed by accepting assets that are inherently illiquid and offering liabilities which are much more liquid (offer a smoother pattern of returns), can make banks vulnerable to a bank run . Emphasizing

2301-567: The event of a negative shock and may engage in precautionary hoarding of funds. This would result in reduction of funds available in the economy and a slowdown in economic activity. Additionally, the fact that most financial institutions are simultaneously engaged in lending and borrowing can give rise to a network effect . In a setting that involves multiple parties, a gridlock can occur when concerns about counterparty credit risk result in failure to cancel out offsetting positions. Each party then has to hold additional funds to protect itself against

2360-416: The global market in natural gas futures. Chincarini notes that firms need to manage liquidity risk explicitly. The inability to sell a futures contract at or near the latest quoted price is related to one's concentration in the security. In Amaranth's case, the concentration was far too high and there were no natural counterparties when they needed to unwind the positions. Chincarini (2006) argues that part of

2419-476: The government imposes an optimal tax to finance the deposit insurance. Alternative mechanisms through which the central bank could intervene are direct injection of equity into the system in the event of a liquidity crunch or engaging in a debt for equity swap . It could also lend through the discount window or other lending facilities, providing credit to distressed financial institutions on easier terms. Ashcraft, Garleanu, and Pedersen (2010) argue that controlling

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2478-409: The hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions. Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but

2537-440: The impact of the initial negative shock. In an attempt to maintain its leverage ratio , the financial institution must sell its assets, precisely at a time when their price is low. Thus, assuming that asset prices depend on the health of investors' balance sheet, erosion of investors' net worth further reduces asset prices, which feeds back into their balance sheet and so on. This is what Brunnermeier and Pedersen (2008) term as

2596-403: The institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Market and funding liquidity risks compound each other as it is difficult to sell when other investors face funding problems and it is difficult to get funding when the collateral is hard to sell. Liquidity risk also tends to compound other risks. If a trading organization has

2655-410: The liquidity cost as the difference of the execution price and the initial execution price. Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost. Hachmeister identifies the fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures, resilience can only be determined over

2714-444: The loss Amaranth incurred was due to asset illiquidity. Regression analysis on the 3 week return on natural gas future contracts from August 31, 2006 to September 21, 2006 against the excess open interest suggested that contracts whose open interest was much higher on August 31, 2006 than the historical normalized value, experienced larger negative returns. Northern Rock suffered from funding liquidity risk in September 2007 following

2773-556: The loss of a large depositor or counterparty." Greenspan's liquidity at risk concept is an example of scenario based liquidity risk management. If several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity, the impact of this is reduced. The American Academy of Actuaries wrote "While a company is in good financial shape, it may wish to establish durable, ever-green (i.e., always available) liquidity lines of credit. The credit issuer should have an appropriately high credit rating to increase

2832-518: The maturity of the foreign debt and the possibility of international default), offer a plausible explanation for the financial crises that were observed in Mexico, East Asia, Russia etc. These models assert that international factors can play a particularly important role in increasing domestic financial vulnerability and likelihood of a liquidity crisis. The onset of capital outflows can have particularly destabilising consequences for emerging markets. Unlike

2891-426: The most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing . Look at net cash flows on

2950-440: The next, there is little standardization in how such analyses are implemented. Regulators are primarily concerned about systemic implications of liquidity risk. Risk-averse investors 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. A common method for estimating

3009-407: The period of time needed to liquidate the portfolio. VAR can be calculated over this time period. The BIS mentions "... a number of institutions are exploring the use of liquidity adjusted-VAR, in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions." Alan Greenspan (1999) discusses management of foreign exchange reserves and suggested

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3068-403: The possibility of trading with a more informed trader. Hachmeister refers to market depth as the amount of an asset that can be bought and sold at various bid–ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid–ask spread accordingly. They calculate

3127-591: The private sector with more liquid government – backed assets, through the following channels: Pre-emptive or ex-ante policy: Imposition of minimum equity -to- capital requirements or ceilings on debt-to-equity ratio on financial institutions other than commercial banks would lead to more resilient balance sheets. In the context of the Diamond–Dybvig model , an example of a demand deposit contract that mitigates banks' vulnerability to bank runs, while allowing them to be providers of liquidity and optimal risk sharing,

3186-472: The purchase of insurance , and collections of user fees such as utility usage and business licenses. Municipal funding sources are commonly property tax , sales tax , income tax , utility users tax (UUT), transient occupancy tax (hotel occupancy), and user fees such as licensing and permit fees. Elected municipal treasurers may only be required to be of legal age, over 18, for example, meet minimum residency requirements, perhaps six months or one year, and be

3245-414: The risks that are not netted out, reducing liquidity in the market. These mechanisms may explain the 'gridlock' observed in the interbank lending market during the recent subprime crisis, when banks were unwilling to lend to each other and instead hoarded their reserves. Besides, a liquidity crisis may even result due to uncertainty associated with market activities. Typically, market participants jump on

3304-467: The role played by demand deposit contracts in providing liquidity and better risk sharing among people, they argue that such a demand deposit contract has a potential undesirable equilibrium where all depositors panic and withdraw their deposits immediately. This gives rise to self-fulfilling panics among depositors, as we observe withdrawals by even those depositors who would have actually preferred to leave their deposits in, if they were not concerned about

3363-477: The subprime crisis. The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets. In response, the FSA now places greater supervisory focus on liquidity risk especially with regard to "high-impact retail firms". Long-Term Capital Management (LTCM) was bailed out by a consortium of 14 banks in 1998 after being caught in

3422-418: The upper bound for a security illiquidity discount is by using a Lookback option, where the premia is equal to the difference between the maximum value of a security during a restricted trading period and its value at the end of the period. When the method is extended for corporate debt it is shown that liquidity risk increases with a bond credit risk. Culp defines the liquidity gap as the net liquid assets of

3481-613: Was essentially a massive, unhedged exposure to a single risk factor. LTCM had been aware of funding liquidity risk. Indeed, they estimated that in times of severe stress, cuts on AAA-rated commercial mortgages would increase from 2% to 10%, and similarly for other securities. In response to this, LTCM had negotiated long-term financing with margins fixed for several weeks on many of their collateralized loans. Due to an escalating liquidity spiral, LTCM could ultimately not fund its positions in spite of its numerous measures to control funding risk. Liquidity crisis In financial economics ,

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