FRM Handbook Ch 26: Liquidity Risk
Book: Financial Risk Manager Handbook Plus Test Bank
Author: Philippe Jorion
ISBN: 978-0-470-90401-5
You can be solvent on paper and still die in a week. That is the core lesson of Chapter 26. Liquidity risk does not show up in a standard VaR number. It shows up when counterparties refuse to roll funding, when depositors line up at the door, and when the only way to raise cash is to sell assets into a market that has stopped buying.
Two sides of the same problem
Jorion splits liquidity risk into two types:
Asset liquidity risk is the risk you cannot unwind a position quickly without moving the price against you. Think bid-ask spreads, market depth, and price impact.
Funding liquidity risk is the risk you cannot meet liabilities as they come due without taking painful losses. Think deposit runs, failed repo rollovers, and margin calls you cannot meet.
These interact badly. If your assets are illiquid, you may have to sell them at fire-sale prices to cover a funding gap. The funding crisis makes the asset crisis worse.
How to think about asset liquidity
The chapter gives practical tools:
- Bid-ask spread: Round-trip cost of a normal-sized trade. Tight spreads mean liquid markets.
- Market impact: How price moves when you trade larger size. Steep impact curves mean illiquid assets.
- Time horizon: Patient sellers can split orders over days and reduce impact. Forced sellers cannot.
- On-the-run vs off-the-run: Newer Treasury issues trade more actively. Similar credit risk, different liquidity premium.
- Fungibility: Exchange-traded assets resell easily. OTC derivatives need counterparty consent to unwind.
A $10 million Treasury trade might cost 0.05% in spread. The same size in bank loans could cost 5% or more. And selling $20 million might push prices down further because the market impact curve is nonlinear.
Liquidity also varies over time. The 1994 bond rout, the 1998 LTCM crisis, and the 2007 credit crisis all featured flight-to-quality episodes where spreads widened everywhere at once.
Liquidity-adjusted VaR
Standard VaR assumes you can exit at the closing price. Jorion shows how to adjust VaR for liquidation costs by incorporating the bid-ask spread and estimated market impact over the liquidation horizon. This is more realistic for large positions in less liquid markets, but it still depends on assumptions about how fast you need to sell.
Funding risk and Northern Rock
The Northern Rock case is the chapter’s anchor example. A British bank that funded long-term mortgages with short-term wholesale borrowing. When securitization markets froze in 2007, Northern Rock could not roll its funding. Depositors panicked. The bank needed an emergency loan from the Bank of England.
The lesson: maturity mismatch is not just an accounting detail. It is a survival risk. Banks with long assets and short liabilities are structurally exposed to confidence shocks.
Managing liquidity day to day
Banks use gap analysis to match asset and liability maturities. They build contingency funding plans for stress scenarios. They disclose liquidity profiles to regulators and markets. None of this is as elegant as a VaR model. All of it matters more during a crisis.
Basel did not impose a formal capital charge for liquidity risk. The committee acknowledged that liquidity is essential to survival and that capital levels affect a bank’s ability to borrow in stress. The absence of a charge is not the same as permission to ignore it.
What stuck with me
Liquidity risk is the one risk type that kills you when everything else looks fine. Your capital ratios can be adequate. Your VaR can be low. And you can still fail because nobody will lend to you tomorrow.
The chapter does not pretend liquidity is easy to model. It gives you vocabulary, measurement hooks, and real examples. That is enough to take it seriously even when your risk dashboard cannot display it cleanly.
Previous: FRM Handbook Ch 25: Operational Risk
Next: FRM Handbook Ch 27: Firmwide Risk Management (Integrated Risk Management)