Liability Dynamics: A New Analytic Framework for Counterparty Risk Management? If Data on Funding Liquidity Can Be Organized into a Theory of Liability Dynamics, It Can Be Used to Supplement Credit Ratings, VaR, and Qualitative Risk Measures in Evaluating Counterparty Risk

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In October 2008, then SEC Chairman Christopher Cox was asked if he thought liabilities were a fruitful field for further regulatory development.

"Yes. The run-on-the-bank experiences of Bear and Lehman, driven by a crisis of confidence, had never occurred before in investment banking," he said. "The rapid flight of customers, such as hedge funds, illustrated the benefits of more 'sticky' sources of financing. The liability side of the analysis certainly has the full attention of regulators."

The Crucible for Calibration

After the collapse of Bear Stearns and Lehman Brothers, investors were shocked to learn that even senior executives failed to appreciate how vulnerable their firms were when denied access to short-term funding markets. Similar funding denials preceded the de facto collapses, shotgun mergers, or bailouts of other large investment banks, as well as AIG, Citigroup, Fannie Mae, and Freddie Mac.

As Fed chairman Ben Bernanke explained, such institutional failures resulted from "poor risk management [since] the spreading of risk, one of the purported benefits of the originate-to-distribute model, proved to be much less extensive than many believed. When investors were no longer willing or able to finance new structured credit products, many of the largest financial institutions had to fund instruments they could not readily sell or had to meet contingent funding obligations for which they had not adequately planned." Simply put, contingent liabilities took down some of the largest, highest-rated counterparties in the world.

The financial market does not suffer shocks lightly. According to a report by the Basel-based Bank for International Settlements (BIS), the central bank for central banks: "Following Lehman Brothers' bankruptcy on 15 September, conditions in financial markets deteriorated to new lows. Liquidity demand surged while perceived counterparty risk rose to record highs, resulting in the virtual shutdown of the unsecured interbank lending market. At the same time, flight to safe-haven government securities intensified. ... Investors …