What Is Liquidity Risk?

Robert Fiedler

We have already intuitively used the expression “liquidity risk” but not yet properly explained what we mean by it. We have considered market and credit risk, which result in a loss or a profit and do not have a time structure (or at least the current measurement methods bypass this by working with present values). Obviously, liquidity risk has some similarity to these value risks (it can, for example, result in comparative funding losses) but some if its perils go beyond just losing money. We will distinguish in this chapter between liquidity risks that are value risks and those which cannot be expressed simply as expected profits or losses.

The difference is important, not only because liquidity does not fit into value risk measures such as VaR, but, more importantly, because it cannot be held against capital as a buffer.

As a starting point, we examine concepts like illiquidity, insolvency and default and establish a common usage of these throughout this book. Advancing this we describe liquidity/illiquidity for financial instruments and markets as well as financial institutions (banks). Finally, we outline liquidity-induced value risks.

Illiquidity

A bank enters into