Finance

What is Liquidity Funding Risk?

Liquidity funding risk:  is concerned with being able to meet cash needs as they arise.

  • It is important for a financial institution to forecast its cash needs in both normal market conditions and stressed market conditions to ensure that they can be met with almost total certainty.
  • Financial institutions that are solvent can, and sometimes do, fail because of liquidity problems.

Liquidity funding problems can be caused by:

  1. Liquidity stresses in the economy; Investors are then reluctant to provide funding in situations where there is any credit risk at all (e.g., a flight to quality such as that seen during the 2007 to 2009 crisis)
  2. Overly aggressive funding decisions; There is a tendency for all financial institutions to use short-term instruments to fund long-term needs, creating a liquidity mismatch.
  3. A poor financial performance, leading to a lack of confidence. This can result in a loss of deposits and difficulties in rolling over funding.

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  • Often, when a company experiences severe liquidity problems, all three of these have occurred at the same time.
  • The key to managing liquidity risk is predicting cash needs and ensuring that they can be met in adverse scenarios. Some cash needs are predictable and some are less predictable
  • As financial instruments have become more complex, cash needs have become more difficult to predict.

For e.g., downgrade triggers, guarantees provided by a financial institution, and possible defaults by counterparties in derivatives transactions can have an unexpected impact on cash resources.

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Example: Ashanti Goldfields:

  • It’s a West African gold-mining company based in Ghana, experienced problems resulting from its hedging program in 1999.
  • It had sought to protect its shareholders from gold price declines by selling gold forward.
  • On September 26, 1999, 15 European central banks surprised the market with an announcement that they would limit their gold sales over the following five years.
  • The price of gold jumped up over 25%.
  • Ashanti was unable to meet margin calls and this resulted in a major restructuring, which included the sale of a mine, a dilution of the interest of its equity shareholders, and a restructuring of its hedge positions

Related: How does Funding Maturity Gap affect Banks?

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