By Michael Leibrock, Ph.D., part-time lecturer of Enterprise Risk Management, Director, Credit Risk Management, Options Clearing Corporation
From a historical perspective, there are countless examples of liquidity risk playing a crucial role in the default or near-default of many well-known, long-standing financial institutions, including Silicon Valley Bank, Northern Rock, and Lehman Brothers, to name a few.
Many of these historical liquidity events were fueled by factors that were not even directly related to firms’ actual liquidity profile. Instead, many were caused by other factors such as concerns related to a firm’s credit profile, external ratings downgrades, internal fraud, regulatory status, or the impact of a specific market event. Such proximate issues sometimes lead to a crisis of confidence in a firm, market rumors (which are sometimes inaccurate) and eventually cause its lenders or the marketplace at large to reduce or even completely cut off financing for fear of not being repaid or of providing new financing to a firm that may be heading for bankruptcy in the very near term.
As explained in Walter Bagehot's Lombard Street: A Description of the Money Market (1873), confidence is the main commodity of the banking system. Bank liabilities are valuable primarily because depositors trust they will be honored on demand; when that trust erodes, even fundamentally sound banks can be brought down by runs.
In my view, it is this unique paradigm that sets liquidity risk apart from other forms of financial risk, given the role that non-quantitative, emotional factors such as confidence and trust have played in financial crises for centuries. It’s quite possible that a financial institution can appear perfectly sound from a capital and credit risk perspective and may even have a solid liquidity profile on paper. For example, a firm might have what appears to be ample sources of liquidity such as committed loan facilities and multiple sources of market financing such as repo or stock loan facilities, and, depending on the size and nature of the firm, it may even have access to capital markets liquidity via bond or commercial paper issuance.
However, at all costs, one must always avoid placing an over-reliance on what I will call “paper liquidity”. As history has shown time and time again, unexpected market events or negative company surprises can prompt an immediate crisis of confidence in a firm, which can spread like wildfire across the financial markets.
Therefore, when it comes to liquidity risk, what really matters in a stressed period for a firm, as much as its liquidity ratios, the existence of financing agreements with lenders and a strong track record of accessing liquidity from the market, is the actual willingness on the part of the lenders and the collective market to continue funding a firm when industry confidence becomes shaken for any number of reasons, whether based on fact or simply rumor and speculation.
The Master of Science in Enterprise Risk Management (ERM) program at Columbia University places strong emphasis on liquidity risk with courses such as Liquidity Risk Management, Financial Risk Management and Systemic Risk. Students learn not only how to evaluate a firm’s liquidity profile quantitatively, which is a vital skill, but also benefit from access to top-tier ERM Lecturers, who share their decades of experience managing liquidity risk through numerous market cycles. Access to this unique learning environment positions ERM students to enter the world of risk management armed with invaluable tools to succeed in an ever-dynamic global risk landscape.
Views and opinions expressed here are those of the author and do not necessarily reflect the official position of Columbia School of Professional Studies or Columbia University.
About the Program
The Master of Science in Enterprise Risk Management (ERM) program at Columbia University prepares graduates to inform better risk-reward decisions by providing a complete, robust, and integrated picture of both upside and downside volatility across an entire enterprise. For both the full-time and part-time options, students may take all their courses on Columbia’s New York City campus or choose the synchronous online class experience.
Learn more about the program here.
