Changes in interest rates can affect the bank’s profit and equity value when assets and liabilities are not properly matched, but this probably won’t cause the bank to become insolvent. Improperly matching the maturities of cash flows (the cash flow gap discussed earlier) could drive the bank to insolvency, but this risk can be managed with planning. A risk that is more difficult to plan for is a liquidity crisis.
What if one or more of the bank’s funding sources were to suddenly become unavailable?
Before the financial crisis, liquidity risk was treated as part of cash management.
But during the financial crisis, banks learned that liquidity problems could be catastrophic. Banks had not experienced problems with liquidity for years, as they could easily raise capital from securitization and through short-term lending in the repo market. But when those sources of funding dried up, some banks were ruined.
Now banks have dedicated staff that analyze hypothetical scenarios to assess the bank’s liquidity gap. These staff monitor early warning indicators that could predict a liquidity event, such as credit rating downgrades, increases in default rates, difficulty issuing debt, etc. They also develop a contingency funding plan with steps for obtaining replacement funding should a liquidity event occur.
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