Types And Causes Of Liquidity Risks Finance Essay - Free Essay Example

There are many causes of liquidity risk liquidity risk actually arises when the one party wants to trading an asset cannot do it because in the market no one wants to trade that asset .The persons who are about to hold or currently hold the asset and want to trade that asset then liquidity risk become partial important to them as it affects their ability to do business. From drop of price to zero is very different from that appearance of liquidity risk. In the case when the assets price drop to zero then market said that asset is valueless. On the other hand when one party found that the other party is not interested in buying and selling of an asset then it become a big problem for the participant of a market to find the other interested party. so we can say that in the emerging markets or low volume markets the risk of liquidity is higher. Due to uncertain liquidity the liquidity risk is known as a financial risk. 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 the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Liquidity risk tends to compound other risks. If a trading organization has 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  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 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 te ndency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but 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 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 organizations 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: Greenspan (1999) discusses management of f oreign exchange reserves. The Liquidity at risk measure is suggested. A countrys 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 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 certain ex ante probability, such as 95 percent of the time. 2.6.3-Scenario analysis-based contingency plans: The FDIC discuss liquidity risk management and write Contingency funding plans should incorporate events that could rapidly affect an institutions liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.Greenspans liquidity at risk concept is an example of scenario based liquidity risk management. 2.6.4-Diversification of liquidity providers: 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 the chances that the resources will be there when needed. 2.6.5-Derivatives: Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk.: Withdrawal option: A put of the illiquid underlying at the market price. Bermudan-style return put option: Right to put the option at a specified strike. Return swap: Swap the underlyings return for LIBOR paid periodicially. Return swaption: Option to enter into the return swap. Liquidity option: Knock-in barrier option, where the barrier is liquidity metric. 2.7-Quantity of Liquidity Risk Indicators: The following indicators, as appropriate, should be used when assessing the quantity of liquidity risk. It is not necessary to exhibit every characteristic, or a majority of the characteristic, to be accorded the rating. 2.7.1-Low: Funding sources are abundant and provide a competitive cost advantage. Funding is widely diversified. There is little or no reliance on wholesale funding sources or other credit-sensitive funds providers. Market alternatives exceed demand for liquidity, with no adverse changes expected. Capacity to augment liquidity through asset sales and/or securitization is strong and the Bank has an established record in accessing these markets. The volume of wholesale liabilities with embedded options is low. The Bank is not vulnerable to funding difficulties should a material adverse change occur in market perception. Support provided by the parent company is strong. Earnings and capital exposure from the liquidity risk profile is negligible. 2.7.2-Moderate Sufficient funding sources are available which provide cost-effective liquidity; Funding is generally diversified, with a few providers that may share common objectives and economic influences, but no significant concentrations. A modest reliance on wholesale funding may be evident. Market alternatives are available to meet demand for liquidity at reasonable terms, costs, and tenors. The liquidity position is not expected to deteriorate in the near term. The Bank has the potential capacity to augment liquidity through asset sales and/or securitization, but has little experience in accessing these markets. Some wholesale funds contain embedded options, but potential impact is not significant. The Bank is not excessively vulnerable to funding difficulties should a material adverse change occur in market perception. The parent company provides adequate support. Earnings or capital exposure from the liquidity risk profile is manageable. 2.7.3-High: Funding sources and liability structures suggest current or potential difficulty in maintaining log-term and cost-effective liquidity. Borrowing sources may be concentrated in a few providers or providers with common investment objectives or economic influences. A significant reliance on wholesale funds is evident. Liquidity needs are increasing, but sources of market alternatives at reasonable terms, costs, and tenors are declining. The Bank exhibits little capacity or potential to augment liquidity through asset sales or securitization. A lack of experience accessing these markets or unfavorable reputation may make this option questionable. Material volumes of wholesale funds contain embedded options. The potential impact is significant. The Banks liquidity profile makes it vulnerable to funding difficulties should a material adverse change occur. There is little or unknown support provided by the parent company. Potential exposure to loss of earnings or capi tal due to high liability costs or unplanned asset reduction may be substantial. Liquidity risk management Achieving best practice Managing liquidity risk is often about applied common sense, like operational risk it requires a firm-wide approach and this places a high demand on the right processes and procedures. Any management information system used to mitigate liquidity risk should be: Accurate The best way of encouraging accuracy is to keep reporting simple. Communicative Report and information should speak plainly. Regular Timely reporting allows managers to judge changes in the market and their organizations liquidity profile. Comprehensive Must reflect your organizational reality, such as different entities, jurisdictions and regulations. Realistic Scenario must be rigorous if risk is to be identified in real situations. 2.8-Quality of Liquidity Risk Management The following indicators, as appropriate, should be used when assessing the quality of liquidity risk management. 2.8.1-Strong Board approved policies effectively communicate guidelines for liquidity risk management and designate responsibility. The liquidity risk management process is effective in identifying, measuring, monitoring, and controlling liquidity risk. Reflects a sound culture that has proven effective over time. Management fully understands all aspects of liquidity risk. Management anticipates and responds well to changing market conditions. The contingency funding plan is well-developed, effective and useful. The plan incorporates reasonable assumptions, scenarios, and crisis management planning, and is tailored to the needs of the institution. Management information systems focus on significant issues and produce timely, accurate, complete, and meaningful information to enable effective management of liquidity. Internal audit coverage is comprehensive and effective. The scope and frequency are reasonable. 2.8.2-Satisfactory Board approved policies adequately communicate guidance for liquidity risk management and assign responsibility. Minor weaknesses may be present. The liquidity risk management process is generally effective in identifying, measuring, monitoring, and controlling liquidity. There may be minor weaknesses given the complexity of the risks undertaken, but these are easily corrected. Management reasonably understands the key aspects of liquidity risk. Management adequately responds to changes in market conditions. The contingency funding plan is adequate. The plan is current, reasonably addresses most relevant issues, and contains an adequate level of detail including multiple scenario analysis. The plan may require minor refinement. Management information systems adequately capture concentrations and rollover risk, and are timely, accurate, and complete. Recommendations are minor and do not impact effectiveness. Internal audit is satisfactory. Any wea knesses are minor and do not impair effectiveness or reliance on audit findings. 2.8.3-Weak Board approved policies are inadequate or incomplete. Policy is deficient in one or more material respects. The liquidity risk management process is ineffective in identifying, measuring, monitoring, and controlling liquidity risk. This may be true in one or more material respects, given the complexity of the risks undertaken. Management does not fully understand, or chooses to ignore, key aspects of liquidity risk. Management does not anticipate or take timely or appropriate actions in response to changes in market conditions. The contingency funding plan is inadequate or nonexistent. Plan may exist, but is not tailored to the institution, is not realistic, or is not properly implemented. The plan may not consider cost-effectiveness or availability of funds in a non-investment grade or CAMEL 3 environment. Management information systems are deficient. Material information may be lacking or inaccurate, and reports are not meaningful. Internal audit covera ge is nonexistent or ineffective due to one or more material deficiencies. 2.9-Common problems and misconceptions: Liquidity  risk  is one of the least understood and most underestimated risks that financial markets participants are exposed to. Reasons for this include: ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Under normal market conditions,  liquidity  problems are not observed ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Liquidity  risk  does not lend itself to readily usable measures ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Despite specific BIS recommendations,  liquidity  risk  management  is left out of capital adequacy calculations due to a lack of control and regulation ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Liquidity  management is often confused with liquidity  risk  management ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Market and credit  risk  management  focus on assets, while  liquidity  risk can stem from liabilities as well Liquidity  risk  is also different in natu re to market and credit  risk  and needs to be thought of differently; ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Normal markets analyses (expected or going-concern situations) are insufficient; liquidity  risk  can only be understood with scenario-based stress testing ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Historical measures of  liquidity  are irrelevant; prospective views are essential ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ Liquidity  risk  cannot be readily hedged, and can only be mitigated against through rigorous monitoring and controls ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¢ The pricing of many instruments does not properly charge for  liquidity