The Heavenly Liquidity Twin : The Increasing Importance of Liquidity Risk
Liquidity and solvency have been called the "heavenly twins" of banking (Goodhart, Charles, 'Liquidity Risk Management', Financial Stability Review -- Special Issue on Liquidity, Banque de France, No. 11, February, 2008). Since...
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| Format: | Policy Research Working Paper |
| Language: | English |
| Published: |
2012
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| Online Access: | http://www-wds.worldbank.org/external/default/main?menuPK=64187510&pagePK=64193027&piPK=64187937&theSitePK=523679&menuPK=64187510&searchMenuPK=64187283&siteName=WDS&entityID=000158349_20091124162523 http://hdl.handle.net/10986/4331 |
| Summary: | Liquidity and solvency have been called
the "heavenly twins" of banking (Goodhart,
Charles, 'Liquidity Risk Management', Financial
Stability Review -- Special Issue on Liquidity, Banque de
France, No. 11, February, 2008). Since these
"twins" interact in complex ways, it is difficult
-- particularly at times of crisis--to distinguish between
them, especially in the presence of information asymmetries
(Information asymmetry occurs when one party has more or
better information than the other, creating an imbalance of
power, giving rise to adverse selection and moral hazard ).
An insolvent bank can be liquid or illiquid, and a solvent
bank may be at times illiquid. In the latter case,
insolvency is not far away, since banking is grounded in
information and confidence, and it is confidence which in
the end determines liquidity. In other words, liquidity is
very much endogenous, determined by the general condition of
a bank, as well as the perception of it by the public and
market participants. Dealing with liquidity risk is more
challenging than dealing with other risks, since liquidity
is the result of all the operations of a bank and it is
fundamentally a relative concept which compares segments of
the balance sheet on the asset and liability sides. It does
not deal with absolutes, like arguably the concept of
capital and it explains why there is not an internationally
recognized "Liquidity Accord". This Working Paper
addresses key concepts like market and funding liquidity and
basic tools to address liquidity issues like cash flows,
liquidity gaps and some selected financial ratios. It aims
at providing an introductory guide to risk assessment and
management, and provides useful and practical guidelines to
undertake liquidity assessments which could prove useful in
preparing Financial Assessment Programs (FSAPS) in member
countries of the Bretton Woods institutions. |
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