Funding liquidity risk is the risk of failing to obtain cash to meet obligations when due. Market or trading liquidity risk is the risk of being unable to transact promptly at a reasonable price. A bank unable to renew a maturing loan has a funding problem. A dealer whose sale moves the market sharply against it has a trading-liquidity problem. Each can worsen the other.
Cash can come from deposits, unsecured borrowing, secured borrowing, asset sales, maturing investments or committed facilities. Sources differ in tenor, cost, collateral and reliability. Equity issuance may strengthen funding over time but is rarely a dependable same-day response to a run. A solvent firm can have a liquidity crisis; a positive book-equity number alone proves neither economic solvency nor access to cash.
Northern Rock relied heavily on wholesale markets to fund mortgages. Disruption of those markets exposed its refinancing dependence and contributed to its 2007 crisis. The lesson is that long-lived assets need funding that remains available when securitization or wholesale markets close.
Common mistakes
- Treating book equity as available cash. Positive equity cannot meet a payment without monetizable resources.
- Capping HQLA against the wrong total. Example 1 allows $26.6667B Level 2, not 40% of the pre-cap stock.
- Calling half-spread a round-trip cost. It is the one-way cost from a mid-price mark.
Bottom line
- Funding liquidity concerns cash access; trading liquidity concerns execution price and speed.
- Leverage and collateral calls can amplify liquidity shocks.
- One-way spread cost is half the full spread times position value.
- Multi-day price risk depends on the declining exposure schedule.
Exam shortcut
For HQLA, apply haircuts and solve caps on the final stock. For liquidation risk, write each day's remaining position before scaling VaR. For a liquidity event, identify the payment deadline and the executable source of cash before considering profitability.
The full lesson (about 3,302 words, 22 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
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