THE ULTIMATE OPERATIONAL RISK: LIQUIDITY

As stated above, the management of all risks and adequacy of the perceived risk appetite of the firm, which was sanctioned when there was an abundance of business and liquidity, does not necessarily take into account that failure has an immediate impact that can lead to bankruptcy. For example, the exposure to counterparty risk was traditionally measured as the outstanding amount plus or minus a profit or loss. Settlement risk was a replacement cost plus a profit/loss. But the credit crunch and ensuing confidence crisis raise the stakes dramatically. Today's analysts may interpret a bank's customer failure as a sign that the bank is overexposed to illiquid or risky sectors, or as the bank's failure to properly value collateral, call margins and manage risks. The bank's credit spread goes up immediately, which has a direct impact on equity value and funding costs. Similarly, a settlement failure may hurt much more than the replacement cost if it is perceived as the inability of a bank to settle OTC deals in adverse market conditions, opacity in back office processes, inefficiency of credit controls.

Liquidity issues seem to derive from the mishandling of risks related to the financial and technical aspects of the trading and banking business, such as funding, portfolio and collateral management, counterparty management, failed settlements and other operational issues. Therefore liquidity risk should be considered the ultimate operational risk rather than a stand-alone risk.

Sources of liquidity risks

There are three main causes of liquidity risk:

1. Market liquidity risk - the risks that assets held in portfolio or pledged as collateral may be mispriced or simply impossible to sell due to adverse market conditions. This is made worse in the world of structured finance with the lack of transparency of the underlying assets; money managers have stopped investing in these assets thereby drying up liquidity.
2. Funding liquidity risk - the funding and funding costs associated with the lending books. Reflecting the lack of transparency in the industry banks have limited lending lines in the interbank market leading to a drying up of funds affecting most credit markets.
3. Counterparty driven liquidity risk - the liquidity risks related to a counterparty's unfulfilled obligations, missed or overdue settlements. Causes can stem from either financial problems with the counterparty, connectivity failures and especially from data mismanagement. The latter occurs across straight-through processing (STP) systems linking risk takers with their execution venues, brokers, custodians and administrators. These systems require complex and frequent database alignment. Failure to process transactions in a timely manner may result in payment failures which, in times of extreme market conditions, can disrupt the firm's liquidity management.