Examine how the various forms of liquidity risk feed into one another and show how liquidity events can heighten systemic risk.
The idea
The forms of liquidity risk reinforce one another. Funding liquidity depends on market liquidity, because lenders set haircuts and margins from collateral prices and volatility, and because assets can be sold for cash only at a price the market will pay. Market liquidity depends on funding liquidity, because dealers and leveraged funds that supply liquidity withdraw when their own funding tightens. The result is a spiral. Losses raise margins and haircuts, forced sales depress prices, and further losses follow. Let E be equity, held fixed, and h1 the higher haircut. Then the new ceiling on assets is Amax = E ÷ h1. The required sale is current assets minus Amax, usually far more than the immediate funding gap. Because institutions hold similar assets and rely on similar short-term funding, one firm's fire sale transmits through prices, margins and confidence to others. That is how a liquidity event becomes systemic. Procyclicality is the keyword.
Formulas
Forced sale after a haircut rise
Sale = A − E ÷ h₁
- A
- current assets, after any price fall
- E
- equity, after any loss
- h₁
- the new haircut
Equity fixed and proceeds used to repay debt. The sale is far larger than the immediate funding gap, because selling also shrinks the collateral base.
A practice question
Which sequence best describes a liquidity spiral?
- Falling asset prices lower margins and haircuts, which eases funding and slows asset sales.Why not: Reverses the mechanism: lenders raise, not lower, margins and haircuts when prices and liquidity fall.
- A borrower defaults, its lender writes off the loan, and the loss is confined to that lender.Why not: Describes an isolated credit loss and not a self-reinforcing liquidity feedback.
- Funding squeeze, forced sales, falling prices, higher margins, then a tighter funding squeeze. - correct
- Rising interest rates increase deposits at banks, which increases the supply of funding.Why not: Invents a stabilising flow; a spiral is an amplifying loop between prices and funding.
In a spiral, funding liquidity and market liquidity amplify each other: forced sales reduce prices, which raises margins and losses and forces further sales.
A harder one
A leveraged fund that is forced to sell a thinly traded asset to meet margin calls depresses its price. Which mechanism best explains how this can spread to other funds that hold different assets but also use leverage?
- Only direct counterparty credit exposure to the first fund transmits losses to other funds in the marketWhy not: Ignores indirect channels such as prices, margins and common holdings, which do not need a direct exposure.
- Price contagion: its sales depress prices of assets others hold, triggering their margin calls and sales - correct
- Exchange rate translation between the funds' reporting currenciesWhy not: Has no link to forced sales and margin calls.
- Regulatory capital requirements that rise immediately for every fund when any fund sells assetsWhy not: Invents a regulatory trigger; the transmission is through prices, margins and funding conditions.
Forced sellers sell liquid holdings as well as the troubled one, and mark-to-market and margin practices spread the effect to others with similar positions and short-term funding.
The hardest tier
A fund holds USD 100 million of assets financed by repo at a 10% haircut (equity USD 10 million). Prices fall 3%, the lender raises the haircut to 15% and the fund sells assets at the new prices, using the proceeds to repay debt. How much must it sell, closest to?
- USD 33.3 millionWhy not: Ignores the 3% price fall and so overstates equity at 10 instead of 7.
- USD 27.0 millionWhy not: Includes the price fall but keeps the old 10% haircut, ignoring the increase to 15%.
- USD 50.3 million - correct
- USD 7.6 millionWhy not: Takes the debt in excess of new borrowing capacity as the sale, ignoring that sales shrink the collateral base.
After the price fall assets = 97, debt = 90, equity = 7. At a 15% haircut maximum assets = 7/0.15 = 46.67. Sale = 97 - 46.67 = 50.33. The spiral is a loss, a tighter haircut and a sale of more than half the book.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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