Survive the droughts, I wish you well: Principles and cases of liquidity risk management

• Date: 01 August 2017
• Author: Bruce Tuckman
• Published date: 01 August 2017
• DOI: http://doi.org/10.1111/fmii.12082

DOI: 10.1111/fmii.12082

ORIGINAL ARTICLE

Survive the droughts, I wish you well: Principles

and cases of liquidity risk management

Bruce Tuckman

Correspondence

BruceTuckman, NYU Stern School of Business,

44West 4th Street, New York, N.Y.10012.

Email:btuckman@stern.nyu.edu.

Thetitle quote is from American Dreamin’ by

Jay-Z.

Abstract

Short-term, liquid assets are highly valued by lenders, but pose liq-

uidity risk management challenges to borrowers. Basic principles to

meet those challenges are to conduct liquidity stress scenario anal-

ysis; to form business plans for each stress scenario; to hold enough

capital to sustain the planned, post-shock balance sheet; and to hold

a large enough liquidity reserve to survive the transition from the

pre- to the post-shock balance sheet. Historical failures, like North-

ern Rock, Bear Stearns, and MF Global have a lot to teach about

implementing these principles. While regulatory frameworks con-

strain liquidity positions, they are no substitute for firm-specific liq-

uidity risk management.

1INTRODUCTION

Liquidity risk is the danger that a business cannot come up with enough cash to meet its obligations or continue its

operations. Financial firms, which exist to intermediate between lenders and borrowers, are particularly exposed to

liquidity risk. A firm will fail if its lenders want their money back when the firm is short of cash and can neither attract

new lenders nor sell assets.

Liquidity risk management analyzes how a firm’s cash position might unfold over time; develops contingency plans

to deal with future cash shortages; and balances the benefits and costs of acquiring stable funding and of holding cash

reserves.

The need to understand this subject extends far beyond senior management and the relatively small number of

professionals working in the area. Anyone who runs a business inside a financial firm should understand the liquidity

risks of the business, the means and costs of mitigating those risks, and how the policies of the larger firm encourage or

discourage good liquidity risk management practices.

Understanding liquidity risk is also essential for customers who regularly borrow from financial firms. Any firm’s

contingency plan—or lack thereof—reveals the extentto which that firm will be able and willing to continue to fund its

customers during a liquidity drought.

c

2017 New YorkUniversity Salomon Center and Wiley Periodicals, Inc.

Financial Markets,Inst. &Inst. 2017;26:153–172. wileyonlinelibrary.com/journal/fmii 153

154 TUCKMAN

TABL E 1 RoadRunner’s balance sheet. $ millions

Assets Liabilities

$200 Five-yearauto loans $150 3-month commercial paper

$50 Equity

$200 Total $200 Total

The goal of this paper is to explain the principlesof liquidity risk, making use of a few cases of past mismanagement.

By way of introduction, consider the example of a (fictional) auto finance company,RoadRunner Loans, which makes

five-year auto loans with funds raisedby selling three-month commercial paper.

RoadRunner’s balance sheet, shown in Table1, is very simple. Its assets are $200 million of five-year auto loans. Its

liabilities are $150 million of commercial paper and $50 million of equity.

The loan book is kept constant at $200 million, with $10 million of outstanding loans coming due everyquarter and

$10 million of new loans made everyquarter. Interest earned on the loan book pays the interest due on the commercial

paper,with any and all excess distributed to the company’s owners.

At the end of every quarter RoadRunner “rolls” its $150 million of three-month commercial paper: it repays the

$150 million of maturing paper by selling $150 million of new paper. Some buyers of RoadRunner’s paper routinely

roll their maturing proceeds to buy new Roadrunner paper,while others take their money and invest elsewhere. But to

whatever extentbuyers do not roll paper in any given quarter, RoadRunner needs to find new buyers.

RoadRunner’s business model, as just described, is exposed to two generic risks: solvency risk and liquidity risk.

Solvency risk is the danger that the value of a firm’s assets falls below the value of its liabilities, wiping out its

capital. In the case of RoadRunner, an insolvency would most likely be the result of defaults byborrowers. But with

$50 million of capital against $200 million of loans, all of which are secured by automobiles, the chances of insolvency

are negligible.

Liquidity risk is the danger of running out of cash. If RoadRunner cannot roll $150 million of commercial paper at

the end of any quarter, either to old or new buyers, it cannot pay off its maturing paper. It can try to borrow money

from other lenders. It can try to sell some of its auto loans. But if these efforts fail, RoadRunner would have to declare

bankruptcy or sell itself to a buyer who can pay off the maturing paper.

Why might RoadRunner not be able to roll its commercial paper? If losses from borrower defaults are expected to

be unusually extreme, then lenders might very well refuse to buy RoadRunner’s commercial paper. In this situation,

liquidity risk and solvency risk are intertwined: liquidity problems arise because lenders fear insolvency.

There are scenarios, however,in which RoadRunner might not be able to roll its paper for reasons that have noth-

ing to do with its own solvency. In a general recession, corporationsmight no longer have any excess cash to park in

commercial paper. Banks might reduce commercial paper holdings to accommodate business clients who drawdown

on credit lines. And individuals, dealing with emergencies ranging from margin calls to unemployment, might withdraw

cash from money marketfunds, which, in turn, invest in commercial paper.

A liquidity crunch or crisis occurs when many businesses, banks, and individuals all want cash at the same time.

These events are quite rare,but, when they occur, businesses like RoadRunner’s might not survive.

RoadRunner’sbusiness model relies on a combination of one of the most stable and one of the most unstable sources

of funding. Equity is one of the most stable: once a dollar of equity has been raised, it never has to be repaid. And

dividendsare notobligatory. By definition, then, a company financed with 100% equity cannot be driven out of business

for failing to make a mandatory payment.

Commercial paper, by contrast, as made clear by the RoadRunner case, is one of the most unstable sources of

funding. It is an example of “wholesale funding,” a category that denotes lending by professional market participants

who are particularly quick to pull funding during a liquidity crunch or upon suspicion that a borrower’s credit has

deteriorated.

Other sources of funding lie between equity and commercial paper on the spectrum of stable funding. Long-term

debt, for example, is particularly stable. In a liquidity crunch, a firm financed with long-term debt has a lot of time to