Liquidity Risk: Funding, Market Liquidity, and LCR/NSFR
The dual nature of liquidity risk, contingency funding plans, Basel liquidity requirements, and why liquidity crises kill banks faster than credit losses.
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Concept visual
Liquidity Buffer Runoff
Liquidity questions become easier when you visualize how quickly usable funding can disappear under stress.
Why it matters
Always compare time-to-cash against time-to-outflow. Liquidity failure is usually a timing mismatch.
Liquidity Risk: Funding, Market Liquidity, and LCR/NSFR
Two Types of Liquidity Risk
Liquidity risk has two distinct but interconnected dimensions:
- Funding Liquidity Risk — The risk that a firm cannot meet its payment obligations without significant cost or business disruption
- Market Liquidity Risk — The risk that a firm cannot exit a position without significantly affecting the market price
In a crisis, these interact in a death spiral: asset prices fall (market liquidity) → margin calls increase → funding dries up (funding liquidity) → forced selling → prices fall further.
Funding Liquidity Risk
Sources
- Maturity mismatch — Borrowing short-term (overnight repo) to fund long-term assets (10-year bonds)
- Depositor/creditor runs — Loss of confidence causes counterparties to withdraw funding simultaneously
- Contingent claims — Collateral calls, credit line drawdowns, and margin requirements that spike during stress
Measurement
- Cash flow gap analysis — Map all contractual cash inflows and outflows by time bucket. Identify gaps where outflows exceed inflows.
- Stress liquidity gap — Same analysis but under stressed assum
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