The 2008 financial crisis and the 2023 banking events dramatically demonstrated the devastating impact of liquidity risk. This topic is critical for FRM success.

Types of Liquidity Risk

Funding Liquidity Risk: The risk of not being able to meet payment obligations when due without incurring unacceptable losses.

Market (Asset) Liquidity Risk: The risk of not being able to sell assets quickly at fair value, often measured by bid-ask spreads and market depth.

These two types are deeply interconnected and can create reinforcing spirals.

Basel Liquidity Standards

Liquidity Coverage Ratio (LCR)

LCR = HQLA / Total Net Cash Outflows over 30 days ≥ 100%

HQLA Levels:

  • Level 1 (no haircut): Cash, central bank reserves, high-quality sovereign bonds
  • Level 2A (15% haircut): Certain corporate bonds, covered bonds
  • Level 2B (25-50% haircut): Lower-quality corporates, equity

Net Stable Funding Ratio (NSFR)

NSFR = Available Stable Funding (ASF) / Required Stable Funding (RSF) ≥ 100%

Promotes longer-term funding stability over a 1-year horizon.

Liquidity Risk Management

Key Management Tools

  • Cash flow gap analysis (maturity ladder)
  • Liquidity buffer management
  • Contingency Funding Plan (CFP)
  • Funds Transfer Pricing (FTP)
  • Early warning indicators

Stress Testing

  • Institution-specific scenarios (credit downgrade, deposit run)
  • Market-wide scenarios (financial crisis, market freeze)
  • Combined scenarios (most severe)

Lessons from 2023

Silicon Valley Bank's failure provided fresh lessons:

  • Digital bank runs can happen in hours (not days)
  • Social media amplifies panic
  • Concentrated depositor bases create vulnerability
  • Unrealized losses become very real when liquidity pressure forces sales

Practice our liquidity risk questions to prepare thoroughly!