Liquidity risk and its management

This chapter explains the causes of liquidity risk and illustrates how regulators have tried to capture liquidity risk in the supervisory regime of Basel III introduced in 2010 by the Basel Committee of Banking Supervision (BCBS). It begins by looking at two important misunderstandings about banking that often lead to major confusion in the discussion on bank stability: the myth of the risk-free bank and the idea that banks can create ‘their own money’. The chapter then traces the origins and the importance of liquidity risk, before focusing on liquidity risk from both the asset and the liability side of the bank balance. It also provides an outline of how bank supervisors in the past dealt with liquidity risks, before discussing the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) and the effects these ratios have on European banks. Finally, the chapter considers the impact of today’s non-conventional monetary policy.