What's new

Liquidity Risk

Thread starter #1
Hi David,

is there any difference between working capital and Net Liquid Assets.

as Net Liquid Assets = Liquid Assets – Volatile Liabilities in core readings it is mentioned that long term debt come under volatile liabilities.but why do we need long term debt for measuring liquidity gap.we only need to fullfill short term liabilities from the working capital concept.

please correct where am i wrong.

Anil
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
#2
Hi Anil,

Yes, material differences: working capital implies a balance-sheet definition (based on current classifications). Net liquid assets is economically-based, more relevant to the bank. Volatile liabilities for some banks may essentially be ST liabilities, but for others they will be scattered in the B/S.

I think an essay could be written on this. Meaning, I don't have a complete answer but i will get us started with my two thoughts on this:

1. Part of this owes to the broad definition of liquidity. Personally, I like to distinguish between solvency (running out of cash) and liquidity (a significantly broader definition that includes solvency). In the FRM, reflecting its intramural personality trait: liquidity risk is slotted under OpRisk and broken (per Culp) into two pieces:

a. funding liquidity risk ("we need cash to pay the short term liabilities")
b. market liquidity risk ("we can't exit this position without taking a bath")

Indeed, market liquidity risk (valuation drops in super senior CDO tranches) was proximate problem with subprime structures. A great recent piece in the Economist: "But we did not believe that prices on AAA assets could fall by more than about 1% in price. A 20% drop on assets with virtually no default risk seemed inconceivable—though this did eventually occur. Liquidity risk was in effect not priced well enough; the market always allowed for it, but at only very small margins prior to the credit crisis." In this case, the first problem is merely paper losses (i.e., market liquidity risk) but, as you know, that starts a chain reaction and suddenly the bank is coping with funding liquidity, credit, maybe even operational risks.

Hopefully, this helps to resolve: if liquidity risk includes plummeting values due to a lack of liquidity, then short/long term balance sheet classification is not a deciding criteria.

2. Related, problems with long-term debt and changes in the status of long-term debt can impact short-term obligations. First, long-term debt has a "short-term portion." But additionally, it may have triggers/convenants/option provisions that suddenly impact short term funding. This concerns the idea that long-term obligations may translate/become a stress on short-term obligations. And more, broadly, we may parse risk types by definition, but they tend to impinge on each other.

So, your neat questions touches on some interesting FRM themes, some quite "testable:"

* working capital, short- and long-term liabilities are accounting (GAAP) definitions. A bank's economic reality is unlikely to correspond/map neatly to the accounting
* liquidity is (technically) a market risk, which sub--divides into FUNDING and MARKET.
* But liquidity risk is "intramural" and plays cause-and-effect with credit, market and operational risk (e.g., liquidity risk is the ultimate operational risk).

Hope that helps...David
 
Top