Managing Systemic Liquidity Risk: Systems and Early Warning Signals

Terry Benzschawel

This article was first published as a chapter in Credit Modelling (2nd edition), by Risk Books.

A defining feature of the financial crisis of 2007–08 was the inability of many financial institutions to roll over existing debt or to obtain short-term financing. Importantly, the inability to obtain financing negatively impacted global financial stability and macroeconomic performance. Many banks had exposure to common asset classes, and there was heavy reliance on the short-term funding of assets. Banks’ attempts to deal with these exposures under crisis spilled over to other markets and institutions, thereby creating a vicious cycle of losses and financial stress. Ultimately, central banks in major economies found it necessary to assume the role of the money market in providing liquidity amid mutual mistrust among financial institutions. The extent of the necessary governmental intervention is evidence of the underpricing of liquidity risk by both the private and public sectors.

The government injection of taxpayer funds into financial institutions to prevent a collapse of the US banking system has proven politically unpopular. This is reflected in the spate of legislation