As US growth slows, equity markets slide and credit crunches, the spectre of liquidity risk was bound to reappear sooner or later. Over the past week or so, commentators have started to cast a critical eye on the liquidity risk implicit in the large equity positions held by some investment funds.

In both investment funds and banks, the ease with which assets can be turned into cash or its equivalent can determine whether an institution survives a crisis to fight another day. Robert Fiedler, a Frankfurt-based liquidity specialist with software house Algorithmics, says that while market liquidity risk and the funding risk built into a bank’s balance sheet are often treated as separate problems, they can become joined at the hip when things go wrong.

“A bank that sees a funding gap [in the weeks ahead] might normally rely on the repo markets to gain liquidity, as this is cheaper than unsecured funding and is balance sheet-neutral as well,” says Fiedler. “But you can’t depend on being able to do this in difficult markets, or if there’s word on the street that the bank is in trouble.”

Instead, says Fiedler, a bank in such a situation might be obliged to sell down its portfolio of securities. But doing this quickly brings with it the problem of market liquidity risk as well as many operational issues. Even if the market in question is relatively deep and is behaving normally, an institution can incur significant costs – and spark unwelcome market rumour – if it tries to liquidate a large position in a short period of time.

If the market is shallow, or is already in crisis-mode, then the problems multiply. That’s why experts agree that the time to take stock of all kinds of liquidity risk – funding risk, market liquidity risk and their interaction – is well before any crisis hits. The most recent Quarterly Review from the Bank for International Settlement puts it this way: “The illusion of permanent market liquidity is probably the most insidious threat to liquidity itself.” According to the report, liquidity is a kind of flytrap for market participants. Markets become artificially liquid as prices rise and participants are drawn in, then turn unpleasantly sticky as they all try to take flight at the same time.

Various new methodologies attempt to put a value on market liquidity risk. (See, for example, paper 2000-E-14 issued by the Institute for Monetary and Economic Studies at the Bank of Japan, which includes a review of existing literature). These new methodologies try to mend some of the simplifying assumptions of the standard value-at-risk approach to market risk management. VAR assumes that that the liquidation of a position will not itself have an impact on the market, that positions can be liquidated in a short period of time and that the bid–offer spread will remain steady.

But, with a few exceptions, the new methodologies say more about the liquidity risk of exiting large positions in normal markets, and the problem of optimising exit strategies in such markets, than about the liquidity risks of abnormal markets. The lesson of 1998, when market turbulence helped bring down Long-Term Capital Management, was that the liquidity that matters is the kind – almost impossible to measure – that persists in a market when it is under extreme stress.

Since 1998, the threat that has really scared banks and their regulators is that of a simultaneous increase in illiquidity and market price volatility that feeds credit concerns and leads to a breakdown in the normal relationships between markets. As various reports and background papers on the problem have attested over the past few years, no single measure captures this kind of stress liquidity risk. Aside from market depth, tightness and resilience, market liquidity in a crisis depends on the nature and diversity of market participants, their reasons for entering the market and the reaction of their credit departments to deteriorating conditions.

A BIS paper on stress-testing practices in large financial institutions pointed out in March 2000 that one way to anticipate market fragilities like this might be to aggregate stress testing results from leading market participants. But the report also noted the many practical challenges of attempting to do this, and said the information would not help banks allocate risk capital as it would not indicate how likely such severe situations were.

It’s difficult to obtain good data on the historical cost of liquidity deficits during market crises, says Algorithmic’s Fiedler, because the data that’s most interesting – panic-stricken sales at low prices on the over-the-counter markets – is the most difficult to track down.

Debate continues on whether VAR itself might make this kind of liquidity crisis worse. In a prize-winning essay reproduced on our features pages, Avinash Persaud of State Street says quantitative market risk models, such as value-at-risk, tell institutions to exit from volatile markets at the same time, and so exacerbate market shocks – though not everyone in the market risk community agrees.

Meanwhile, the long-term drift in the banking industry away from funding based on customer core deposits, and towards money market funding sources of various kinds, means that liquidity risks of various kinds are on an upward trend.

This, along with the shifting liquidity structure of some critical financial markets – such as the government debt market in the US – means there’s only one certainty. The next market liquidity crisis won’t be a re-run of 1998, or of any other historical example.

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