Silicon Valley Bank entered 2023 solvent on a mark-to-model basis but with $90 billion of held-to-maturity Treasuries sitting in unrealized losses. When a tweet on a Wednesday triggered $42 billion of deposit outflows in 24 hours, the bank discovered that "unrealized" became "realized" the moment those bonds were sold to fund the run. Solvency and liquidity are not the same number, and the exam tests whether you can keep them apart.
A firm fails for liquidity reasons in one of two ways. Either it cannot raise enough cash to meet obligations on the day they come due: that is funding liquidity risk. Or it owns assets it cannot sell at a fair price fast enough to convert them into cash: that is market liquidity risk, sometimes called trading liquidity risk. The two interact and reinforce, but they are distinct problems with distinct controls.
Northern Rock failed in 2007 from funding liquidity. The bank had funded a fast-growing UK mortgage book on three-month wholesale paper.
Common mistakes
- Treating LCR and NSFR as the same ratio. LCR is a 30-day stress test; NSFR is a one-year structural test. A bank can pass one and fail the other. Trap: a question gives you one-year stable-funding figures and asks for LCR: wrong horizon, wrong ratio. Match the time frame to the formula.
- Forgetting the 75% cap on inflows. LCR's denominator is net cash outflows, but inflows are capped at 75% of gross outflows. A bank with $90B outflows and $80B expected inflows cannot use $80B in the denominator, only $67.5B.
- Mis-applying HQLA caps. Level 2 caps at 40% of total HQLA; Level 2B sub-caps at 15%. Both caps apply to the post-haircut, post-cap total. The arithmetic is iterative: shrinking Level 2 changes the total HQLA against which the cap is computed.
Bottom line
- Funding liquidity = ability to meet cash obligations as they fall due. Market (trading) liquidity = ability to sell assets without moving the price. Different problems, different tools.
- Liquidity-adjusted VaR adds to standalone VaR. Spreads widen in stress, so the stress-spread term often dominates the static spread.
- Basel III LCR = HQLA divided by 30-day net cash outflows, minimum 100% (short-horizon stress). NSFR = available stable funding divided by required stable funding, minimum 100% over one year (structural).
- HQLA tiers: Level 1 (cash, central-bank reserves, high-grade sovereigns) at 100%, no cap; Level 2A at 85% with a 40% Level 2 cap; Level 2B at 50-75% with a 15% sub-cap; caps resolve iteratively.
Exam shortcut
When a question shows you HQLA with multiple tiers, run the cap check before the haircut. If raw Level 2 (2A + 2B) exceeds 40% of total HQLA after factors, the cap binds and Level 2 must shrink. The exam likes problems where the cap is exactly the discriminator between two answer choices, so verify the cap before computing the ratio.
The full lesson (about 3,278 words, 22 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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