Liquidity stress: an underestimated risk

Credit defaults and asset prices collapses are generally considered as the two risk factors in financial markets. Thus, extreme events in finance will mainly refer to the amplitude, diffusion and duration of such market shocks. However, global market liquidity may also suffer huge breaks out, where spill over effects depend on the vulnerability and complexity of the interbank relationship. Such events may be quickly lethal for unprepared market participants.

Liquidity stress: two lessons from the French money market

Most financial crises stem from forex problems. When the currency is attacked the Central Bank raise interbank rate and withdraw liquidity from the money market, thus placing banks and money market funds under pressure. Speculations against the French Franc, in the 90’ offer textbook demonstration of such events. Liquidity stress may also spread over the whole market, due to reckless balance-sheet transformation. In the wake of the subprime crisis, interbank markets were nearly shut down because, in the context of the race against ever slimmer yield, many asset managers had forgotten to carefully manage the balance of asset and liabilities durations.

This time is NOT different

As the Internet, the Subprime-Lehman and the Eurozone debt crises clearly demonstrated, extreme events occurs more frequently and more intensively now than in previous centuries. This is due, among other factors, to the huge derivative market and its infinite interconnections. This « new normal » of market accidents should urge fund managers and banks asset and liabilities managers to pay closer attention to liquidity risk within their positions.

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