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rom Zero to Trillion: How a Liquidity Crisis Brings Down Financial Giant
In the turbulent financial markets, the impact of liquidity crisis is everywhere. Liquidity risk is a financial risk that a particular financial asset, security or commodity cannot be traded quickly over a period of time without affecting its market price. The reason behind this risk mainly comes from the lack of willingness to trade among market participants. In this context, why do financial institutions face the challenge of liquidity crisis? By distinguishing between market liquidity and capital liquidity, we can understand this phenomenon more deeply.
Liquidity risk is particularly important for those who will hold or currently hold assets because it affects their ability to trade.
Types of liquidity risk
Liquidity risk is mainly divided into market liquidity and capital liquidity. Market liquidity risk indicates that an asset cannot be quickly converted into cash due to insufficient market liquidity, which is a subcategory of market risk. Liquidity refers to the possibility that funding needs may not be met at an appropriate price when liabilities mature. This risk can be not only a liquidity problem of a specific asset, but also a systemic problem.
Causes of liquidity risk
The emergence of liquidity risk is usually related to the lack of demand for a particular asset by market participants. If there are not enough counterparties in the market, investors who want to sell an asset will face difficulties. Heightened liquidity risk is more common in emerging markets or low-volume markets.
Liquidity risk can also exacerbate other risks. For example, when trading institutions hold assets that are difficult to liquidate, their ability to increase capital in the short term will be reduced, thereby stimulating market risks.
Case Study of Liquidity Crisis
Amaranth Advisors
In 2006, Amarante Advisors lost about $6 billion from concentrated investments in the natural gas futures market. Its positions in the market are too concentrated, resulting in the inability to find counterparties when closing positions is required. This incident highlights the close connection between liquidity risk and industry concentration.
Northern Rock
In 2007, Northern Rock Bank encountered a liquidity crisis due to the US subprime mortgage crisis. Although the company was healthy at the time, it was unable to obtain funds in the short-term capital markets, resulting in difficulties in cash turnover and ultimately had to seek assistance from the British government.
Long-Term Capital Management (LTCM)
In 1998, Long-Term Capital Management was rescued by 14 banks due to a liquidity crisis because its balance sheet had problems due to market economic shocks. This incident reminds us once again how important it is to manage liquidity risk.
Measures for managing liquidity risk
Effective management of liquidity risk is critical. In the measurement of liquidity risk, "liquidity gap" is a commonly used indicator, which refers to the portion of a company's net current assets that exceeds its volatile liabilities. In addition, scenario analysis and forecasting models can help institutions better understand changes in future cash flows and adjust their asset-liability structure in a timely manner.
As demonstrated by many financial institutions around the world, establishing diversified sources of liquidity provision is an effective way to reduce liquidity risk.
Conclusion
The impact of a liquidity crisis often spreads across financial markets and can lead to the collapse of large companies. How to effectively manage potential risks and maintain market stability will be an ongoing challenge. In the face of an ever-changing market environment, how should we reassess and respond to liquidity risks?
