Foundations of Liquidity Risk Management

Kuntal Sur and Kaustav Bhattacharjee

This article was first published as a chapter in Managing Illiquid Assets: Perspectives and Challenges, by Risk Books.

An elusive and formless threat, liquidity risk requires a contrast of two time periods to convince us of its obscurity and severity. First, the Greenspan period of the early 1990s until mid 2005: a period of buoyant asset markets with reducing interest rates, high leverage, underpriced risks with unidirectional upwards asset prices and tamed inflation; in sum, markets flush with liquidity with little regard to credit quality, and the “Greenspan Put”11See http://en.wikipedia.org/wiki/Greenspan_put (accessed July 2010). The Federal Reserve’s pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices. leading to a hungry risk appetite by investors and the concept of risk appetite being applied very loosely. Liquidity risk was considered to be of merely academic interest, and a possible threat, not specific in nature. Fast forward to 2010, and the financial turmoil had caused 322 US banks to fail (25 in 2008, 140 in 2009 and 157 in 2010),22See the list of bank failures in the US at http://en.wikipedia.org/wiki/List

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