Liquidity Risk

🌊 Liquidity Risk: The Water Tank Story

Imagine you run a lemonade stand. You need water in your tank to make lemonade whenever customers come. What if your tank runs dry? That’s liquidity risk!

🎯 What is Liquidity Risk?

Liquidity means having cash (or things you can quickly turn into cash) ready when you need it.

Liquidity Risk is the danger that you won’t have enough cash when bills come due.

🏠 Simple Analogy: The Water Tank

Think of a bank like a house with a water tank:

• Water = Cash
• Tank = Bank’s reserves
• Pipes bringing water in = Deposits from customers
• Faucets letting water out = Withdrawals and loans

If more water flows OUT than IN, your tank empties. That’s trouble!

📚 The Two Types of Liquidity Risk

1️⃣ Funding Liquidity Risk

“Can I pay my bills tomorrow?”

This is when a bank can’t get enough money to meet its obligations.

Real Example:

• A bank promised to pay back $100 million to investors tomorrow
• But deposits came in slower than expected
• The bank is $20 million short!
• Now it must scramble to borrow money (often at high cost)

Why it happens:

• Depositors withdraw money suddenly
• Investors won’t lend anymore
• Loans the bank made aren’t being repaid on time

graph TD
    A["🏦 Bank Needs Cash"] --> B{Can It Get Money?}
    B -->|Yes| C["✅ Safe"]
    B -->|No| D["⚠️ Funding Liquidity Risk!"]
    D --> E["Must Sell Assets Fast"]
    D --> F["Borrow at High Rates"]

2️⃣ Market Liquidity Risk

“Can I sell my stuff quickly without losing money?”

This is when a bank can’t sell assets fast enough or has to sell them at a big discount.

Real Example:

• A bank owns $50 million in corporate bonds
• Suddenly needs cash today
• But nobody wants to buy those bonds right now
• The bank is forced to sell them for only $35 million
• Lost $15 million just because of bad timing!

Why it happens:

• Market is panicking (everyone wants to sell, nobody wants to buy)
• The asset is unusual or complex
• Too many sellers, not enough buyers

Key Difference:

📊 How Banks Measure Liquidity

Banks use special ratios like report cards to check their liquidity health.

💧 Liquidity Coverage Ratio (LCR)

“Do I have enough water for a 30-day drought?”

The LCR makes sure banks have enough high-quality liquid assets (HQLA) to survive 30 days of stress.

The Formula:

LCR = High-Quality Liquid Assets ÷ Net Cash Outflows (30 days)

Must be at least 100% (you need MORE assets than outflows)

Example:

• Bank has $150 million in HQLA (cash, government bonds)
• Expected net outflows in 30 days of stress: $120 million
• LCR = 150 ÷ 120 = 125% ✅ (Above 100%, bank is safe!)

What counts as HQLA?

• 🥇 Level 1: Cash, central bank reserves, government bonds
• 🥈 Level 2A: High-quality corporate bonds (with haircut)
• 🥉 Level 2B: Corporate bonds, stocks (bigger haircut)

🏗️ Net Stable Funding Ratio (NSFR)

“Do I have enough stable water sources for the whole year?”

While LCR looks at 30 days, NSFR checks if the bank can survive 1 year of funding stress.

The Formula:

NSFR = Available Stable Funding ÷ Required Stable Funding

Must be at least 100%

What’s “Stable Funding”?

• Customer deposits that stick around
• Long-term borrowing
• The bank’s own money (equity)

Example:

• Bank has $500 million in stable funding sources
• Needs $450 million to cover its long-term assets
• NSFR = 500 ÷ 450 = 111% ✅

graph TD
    A["📊 Liquidity Ratios"] --> B["LCR"]
    A --> C["NSFR"]
    B --> D["30-Day Survival Test"]
    C --> E["1-Year Stability Test"]
    D --> F["High-Quality Assets ≥ 100%"]
    E --> G["Stable Funding ≥ 100%"]

🧪 Liquidity Stress Testing

“What if everything goes wrong at once?”

Banks run pretend disaster scenarios to see if they’d survive.

Common Stress Scenarios:

1. Bank-Specific Crisis

   • Bad news about the bank spreads
   • Customers panic and withdraw 20% of deposits
   • Other banks refuse to lend

2. Market-Wide Crisis

   • Whole economy is in trouble
   • Asset prices crash
   • Everyone hoards cash

3. Combined Crisis (Worst Case)

   • Both happen together!

Example Stress Test:

📋 Contingency Funding Plan (CFP)

“What’s our emergency plan when the water stops?”

A CFP is the bank’s playbook for emergencies. It answers: “What do we do if we run out of cash?”

A Good CFP Includes:

1. Early Warning Signs

   • Deposits dropping
   • Credit rating downgrade
   • Rising borrowing costs

2. Action Steps by Severity

3. Communication Plan
   • Who talks to regulators?
   • What do we tell customers?
   • How do we prevent panic?

Example: When Lehman Brothers collapsed in 2008, banks without good CFPs froze. Those with plans could act fast and survive.

🏃 Bank Runs: The Ultimate Liquidity Nightmare

“Everyone wants their water at once!”

A bank run happens when many customers rush to withdraw their money at the same time because they fear the bank will fail.

Why Bank Runs Are Dangerous

Banks don’t keep all deposits in cash. They lend most of it out.

Typical Bank Balance:

• Takes in $100 in deposits
• Keeps $10 in cash (reserves)
• Lends out $90

Problem: If everyone wants their $100 back at once, the bank only has $10!

🎬 Famous Bank Runs

1. Northern Rock (2007, UK)

• First UK bank run in 150 years
• Lines of people outside branches
• Government had to guarantee deposits

2. Silicon Valley Bank (2023, USA)

• $42 billion withdrawn in ONE DAY
• Fastest bank run in history (thanks to mobile banking)
• Bank collapsed in 48 hours

🛡️ How to Prevent Bank Runs

graph TD
    A["😰 Fear Spreads"] --> B["Customers Rush to Withdraw"]
    B --> C["Bank Runs Out of Cash"]
    C --> D["Bank Sells Assets at Loss"]
    D --> E["Bank Becomes Insolvent"]
    E --> F["More Fear = More Withdrawals"]
    F --> A

    G["🛡️ Deposit Insurance"] -.-> A
    H["🏛️ Central Bank Help"] -.-> C

🎯 Quick Summary

💡 Key Takeaways

1. Cash is King — Banks need liquid assets ready at all times
2. Two Risks — Can’t raise money (Funding) vs. Can’t sell assets (Market)
3. 100% Minimum — LCR and NSFR must both be at least 100%
4. Plan Ahead — Stress tests and CFPs prepare banks for the worst
5. Confidence Matters — Bank runs are often about fear, not reality

Remember: A bank is like a water system. Keep the tank full, know where backup water comes from, and never let customers doubt the supply! 🌊