Liquidity risk is one of the major risks faced by financial entities (such as banks, insurance companies and pension funds) and one of the primary causes of the 2008 financial crisis. Yet many entities with financial exposure cannot quantify the liquidity risks to which they are exposed.
In layman’s terms, liquidity risk can be described as the risk that arises from being unable to sell an asset in a timely manner and for its “true value.” There are two key dimensions of liquidity risk: one, the time required to transact in an asset, and two, the price at which the asset can be bought or sold.
In a portfolio of securities listed on an exchange, such as a typical equity portfolio, the displayed bid-ask spread can be measured and somewhat managed. However, fixed income securities do not trade on an exchange and bid-ask is generally obtained by calling a dealer or eliciting a quote over an electronic network.
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While liquidity in fixed income is often perceived to be very high, it may depend on the security being traded. For example, government bonds have a higher degree of liquidity than corporate bonds based on the above definition. As well, there are portfolios of assets that can be considered less liquid. Examples of these asset classes include hedge funds, private equity, mortgages, real estate and infrastructure. These portfolios of less-liquid assets are typically overseen by managers in either closed or open investment fund structures. Since the managers of these portfolios may not be able to readily buy or sell the underlying assets of the investment fund, the investment fund structure incorporates elements to manage this risk.
In an asset-liability context, the liquidity of liabilities must also be considered. Liabilities can be categorized as “negative assets”; therefore, the greater the liquidity of the liability, the more risk it poses to the issuer of the liability. For example, a financial entity that takes demand deposits allows the depositor to withdraw the balance at will, which presents a high degree of liquidity risk to the entity. On the other hand, guaranteed investment certificates (GICs) provide a lower degree of liquidity risk to these same entities as GICs are often non-redeemable, which means the only outbound cash flow occurs at maturity. The lower risk comes at a cost, however, since GICs pay a higher rate of interest than deposits.
For pension funds, a pension promise usually only presents liquidity risk at the time of retirement (when cash must be disbursed to the retiree). Therefore, the liquidity risk of the pension promise depends on the time period of measuring such risk. In the period of employment, assets accumulate in the pension fund and the liquidity risk is low. Once the retirement phase has begun, the liquidity risk is equivalent to the pension payments due to the retiree. A pension fund—particularly a fund with many plan members—must consider the liquidity risk of the entire plan. Therefore, a mature plan with more retirees than active members may be facing higher liquidity risk, which could be demonstrated by a negative cash flow in the pension fund: payments to retirees exceed the contributions and the cash being generated by investments.
Read: Managing longevity risk
By incorporating both assets and liabilities, a consideration of pension fund liquidity risk can be assessed. The pension fund’s overall liquidity risk can be measured by modelling the cash requirements of the pension fund liabilities and the cash flows of the assets.
From a total pension fund perspective, a third element to the liquidity risk puzzle has now been introduced: cash flows. The frequency of cash flows increases liquidity risk for liabilities; therefore, it should decrease the liquidity risk of assets. This remains true for any cash flows so long as they are available to the asset owner. For example, dividends for equities, coupons and maturities for fixed income and mortgages, net operating income for real estate, and cash flow available for distribution in infrastructure can be considered for reduction of liquidity risk. This would not be the case, however, if the assets are owned by a closed fund and the investment fund manager retains discretion over cash flow distributions to the unitholders.
Managers of financial entities must maintain oversight of liquidity risk at all times to ensure that cash flow needs are met. For pension funds, the nature of liquidity risk is changing as DB plans mature. While this change has mostly occurred on the liability side of the balance sheet, increased investment in less liquid asset classes has made it imperative for pension funds to recognize liquidity risk.
In upcoming posts, I’ll describe different methods of managing liquidity risks in less liquid asset classes.