Liquidity and Treasury Risk Measurement and Management
Two faces of liquidity
Funding liquidity is the ability to meet cash obligations; market liquidity is the ability to trade without moving price. They reinforce each other in a liquidity spiral: falling prices trigger margin calls, forced sales deepen the price fall, haircuts rise, and funding dries up.
The Basel ratios
LCR = high-quality liquid assets / net cash outflows over a 30-day stress >= 100%. HQLA is tiered: Level 1 (cash, central bank reserves, top-quality sovereigns, no haircut), Level 2A (15% haircut, capped at 40% of the pool), Level 2B (25-50% haircuts, capped at 15%). Inflows are capped at 75% of outflows. Runoff assumptions are prescribed: stable retail deposits 5%, less stable retail 10%, operational wholesale 25%. NSFR = available stable funding / required stable funding over one year >= 100%.
Managing the balance sheet
Know the repricing gap, duration gap, liquidity gap (maturity bucket mismatch), stress testing under idiosyncratic, market-wide and combined scenarios, the contingency funding plan, and funds transfer pricing as the tool that charges business lines for the liquidity they consume. Intraday liquidity and collateral management are increasingly tested.
Liquidity-adjusted VaR
LVaR adds the cost of unwinding a position. Exogenous spread is the market bid-ask; endogenous spread grows with position size relative to normal volume. LVaR = VaR + 0.5 x (exogenous + endogenous spread) x position, or VaR grossed up by a liquidity horizon.
Traps
Forgetting the Level 2 caps and the 75% inflow cap is the most common error. NSFR is a one-year ratio; LCR is thirty days. Do not treat committed but undrawn facilities as HQLA.
Worked example
HQLA $120m, outflows $100m, inflows $20m (capped at $75m, so allowed in full). Net outflows = $80m. LCR = 120/80 = 150%.