ABSTRACT
Liquidity is a long-standing issue and also an elusive concept (Grossman and Miller, 1988). It cannot be observed directly, because it measures the ease of trading an asset. More precisely, it measures the asset’s ability to be sold as soon as possible without causing a significant price movement. This is why it is difficult to capture liquidity in a single measure (bid-ask spread, trading volume, etc.). Moreover, liquidity risk generally refers to two related notions: market liquidity and funding liquidity. Market liquidity concerns assets. For instance, the most liquid asset is cash because it can always be used easily and immediately. Many stocks and sovereign bonds are considered fairly liquid, because they can be sold in the day. On the contrary, private equity and real estate are less liquid assets, because it can take months to sell them. Funding liquidity concerns asset liability mismatch due to liquidity and maturity transformation activities. According to Drehmann and Nikolaou (2013), funding liquidity is defined “as the ability to settle obligations with immediacy. It follows that, a bank is illiquid if it is unable to settle obligations in time”. The concept of funding liquidity is of course important for banks, but also for other financial entities (insurance companies, asset managers, hedge funds, etc.).
This chapter is organized as follows. The first section is dedicated to the measurement of asset liquidity. In the second section, we consider how funding liquidity affects the risk of financial institutions. The last section presents the regulatory framework for managing liquidity risk in a bank. This chapter may be viewed as an introduction of liquidity risk, which is developed in Chapter 7, which focuses on asset liability management risk and is complemented by Chapter 8, which is dedicated to the systemic risk, because liquidity and systemic risks are highly connected.
