Liquidity risk is one of the major risks faced by financial intermediaries and banks in particular. This was clearly demonstrated in the recent financial crisis. Its management is, therefore, crucial to the viability of banks. In this paper we propose a measure of liquidity risk that is based on the structure of the balance sheet of the bank. The measure considers exogenous market conditions as well as policy variables of the bank. Within a behavioral stylized model of a bank that maximizes its expected profits we investigate the effects of market parameters and market structure on liquidity risk. The main results of our model are that liquidity risk exposure is affected by market structure and interest rate sensitivity (market discipline). For example, the risk increases when competition in the loan market increases, while increasing interest rate sensitivity in the deposit market will decrease liquidity risk. Our results are consistent with recent developments in the financial markets, such as increased competition and increased risk aversion of investors that affected interest rate sensitivity.

The traditional functions of commercial banks (depositories) are the transformation of maturity and the provision of liquidity. Banks transform short-term liquid liabilities into long-term illiquid assets. In performing these functions banks provide liquidity to demand depositors and also to borrowers to whom they provide lines of credit. However, in performing these functions they are transferring liquidity risk from their customers to the bank, thus exposing the bank to this risk.

Liquidity in banking is conventionally defined as the ability to meet its obligations as they become due.

Banks may encounter liquidity risks the inability to meet its liquidity needs because of bank-specific problems or because of a market liquidity shortage in times of a financial crisis. Bad news about bank-specific events such as ratings downgrades may lead to a loss of market confidence in the bank adversely impacting its liquidity position. In recent years increase in off-balance sheet activities and a shift to more volatile funding sources have increased this type of risk. Market liquidity risk is the risk that the bank will be unable to sell or unwind its asset position without adversely affecting market prices because of inadequate market depth or market disruption. Bank-specific risk is more important in the context of maturity transformation in the banking book, which consists mainly of illiquid assets, while the market risk is more important in the trading book of the bank that has mostly marketable assets.

In the 2008 financial crisis in the U.S. and other developed economies financial intermediaries encountered specific liquidity problems (withdrawal of funds) as well as “evaporation” of liquidity in the markets that created solvency problems. They were provided with liquidity by the Federal Reserve, bailed out by the government, or became insolvent and had to sell themselves or file for bankruptcy. This demonstrated that liquidity is a major risk in banking and that liquidity management should be a top priority for bank management and regulators.

In the past few years, greater market integration and financial innovation have led to rapid growth in bank loans. These developments increased the reliance of banks on wholesale volatile funding including securitization. More stable sources of funding such as retail deposits declined in importance. These developments resulted in banks’ greater exposure to liquidity risk.

To manage its liquidity needs the bank can raise liquidity on the liability side or act on the asset side. The bank can hold high quality liquid assets and draw on them in the event of liquidity shortage. Of course, liquid assets offer lower returns. Thus, holding more liquid assets and better matching cash-flows of assets and liabilities will reduce the liquidity risk of the bank and protect it from insolvency but also reduce its profitability. Liquidity management, therefore, involves finding the right balance between liquidity risk and profitability. The recent crisis has proven that banks held insufficient liquid assets and assets that they thought were liquid turned out not to be as trading stopped.

In this paper, we present a partial equilibrium model for the management of liquidity by a bank that faces uncertain withdrawal of funds (withdrawal of deposits and utilization of loans commitments) as well as the possibility of an exogenous market liquidity crisis. We relate liquidity risk to risk of default of the bank due to credit risk. Using a cash-flow approach we obtain explicit results concerning optimal liquidity risk management and the factors that affect it. A key feature of our model is the composition of the balance sheet: we relate liquid (short term) assets to volatile rate-sensitive liabilities where the difference between the two is the net liquidity position of the bank (deficit or surplus) and is a measure of its exposure to liquidity risk.

The main results of our model is that liquidity deficit (withdrawal of funds net of liquid assets) of the bank will increase when competition in the loan market increases, while increasing interest rate sensitivity in the deposit market will decrease the liquidity deficit. We offer an interpretation of interest rate sensitivity as a measure of market discipline that is affected by risk aversion of investors in the market. A financial crisis will increase this sensitivity by reducing the “appetite” for risk of investors. This is compatible with the observed increased liquidity risk faced by banks due to the recent developments in financial markets such as consolidation, deregulation, and financial innovation that have affected competition and risk taking by financial institutions.