Liquidity risk in financial institutions


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Title Liquidity risk in financial institutions
Period 01 / 2007 - 01 / 2010
Status Completed
Research number OND1320613
Data Supplier Website CTIT


Risk models in banks typically aim at quantifying likely losses over a given time horizon in various separate risk domains. Formal risk quantification is not only deemed to be of value by practitioners but also required under new supervisory frameworks in the banking world (Basel II). Despite a large increase in sophistication in numerous areas, risk theory falls short in addressing one basic risk: illiquidity. Financial institutions face the essential problem to find the right balance between their assets and their liabilities. In traditional commercial banks assets are less liquid than the liabilities. Associated with this discrepancy is the chance of pressure situation which could leave the bank unable to service their obligations or fund its assets. A classical example is the bank run in which perceived concerns about creditworthiness result in substantial deposit withdrawals by clients. Thus at the core of the business of banks is the management of cash flows in order to maintain a prospective equilibrium. Since the severe consequences liquidity crunches may have on a bank, effective management of liquidity risk is crucial for the sustained survival of a bank. Current liquidity risk management in banks is geared towards preventing liquidity to vanish by pursuing or prescribing sensible actions rather than deriving a rigorous method to quantify the risk. However, a meaningful treatment of liquidity risk in financial institutions should consist of two equally important parts: (1) quantification and (2) management. However, prior to engaging in any of the two, there is a need for a throughout clarification of the meaning of liquidity risk and its various propositions. This is crucial as one cannot measure what one does not understand. Similarly, measurement should precede management. The research questions can be stated as follows: A. What is liquidity risk and what are its significant characteristics? B. How can liquidity risk be rigorously quantified? C. How can liquidity risk be mitigated? D. How can a suitable limit setting be derived on basis of risk budgeting? In case the project succeeds in answering the research questions banks can expect to (1) satisfy regulators requests for a quantification of liquidity risk, (2) reduce liquidity risk, and (3) enhance the management of business units through methodical risk budgeting based on theproposed risk measures.

Related organisations

Secretariat CTIT (UT)

Related people

Project leader Dr. B. Roorda


D70000 Economics and Business Administration

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