Ebook The management of liquidity risks
Recent events have once again demonstrated that liquidity is a fundamental cause of economic shocks. We suggest that actuaries can play a vital role in the development and maintenance of solutions that deal with liquidity risk.
Liquidity risk falls into a separate category to other risks because it emerges only occasionally and is not directly addressed by raising additional capital. It can also be described as a consequential risk that follows losses from other sources.
We are particularly concerned with the systemic risk that arises when the number of willing buyers or sellers in a market dries up for reasons that may not be related to the financial soundness of particular organisations. The effects can lead to share or bond price bubbles or collapses, bank runs or significant drops in market turnover.
We use the 2007 liquidity crunch in the market for various innovative loan instruments to provide an illustration of a liquidity crisis, and to examine the causes and effects.
The paper then considers current liquidity issues and the role of central banks, regulators and markets. It goes on to identify groups of long term investors and borrowers, who do not necessarily require immediate liquidity. While it may not always be the case, the current environment shows that there can be cost savings and yield gains if investors are prepared to surrender immediate liquidity. Matching these groups and obtaining these gains requires innovative approaches that actuaries are well equipped to consider. We describe a few possibilities.
The presence of asymmetric information has been identified as a major contributor to the losses suffered in this past year. In part 4, we suggest that investors can gain real insight into mortgage backed instruments by using actuarial modelling techniques.
CONTENTS
1. Introduction
- 1.1 Definitions
1.2 Text book causes
1.3 The role of government
1.4 The cost of liquidity
1.5 Theory
2 The 2007 credit crunch
- 2.1 The crunch in short
2.2 Measurable effects
2.3 Causes
2.4 A historical perspective
3 Avoiding liquidity crises
- 3.1 Actively manage liquidity
3.2 Create sources of liquidity
3.3 Match investors and borrowers by term
3.4 Avoid making liquidity promises
3.5 Charging for liquidity
3.6 Illiquid liabilities have lower value
4 Building better models
- 4.1 Portfolio or loan modelling?
4.2 Key assumptions
4.3 The cash flow model
4.4 Modelling the securitisation structure
4.5 Common structures
4.6 Credit enhancement
5 Conclusion
6 References
- Appendix A Liquidity required of banks
Appendix B Some technical details
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