Academic journal article Journal of Money, Credit & Banking

Liquidity and Risk Management

Academic journal article Journal of Money, Credit & Banking

Liquidity and Risk Management

Article excerpt

THIS PAPER IS CONCERNED with the corporate demand for liquidity and the various ways in which firms in the real and the financial sectors manage their liquidity needs so as to be able to carry out production and investment plans effectively without being held back by temporary liquidity shortages. Several key decisions impact a corporation's future ability to avail itself of financial funds.

First, the corporation's capital structure sets, among other things, a timetable for reimbursing investors. Short-term debt forces the firm to pay out cash, drying up liquidity. Long-term debt allows the firm more room to adjust to liquidity shocks, exerting pressure mainly by the constraints it places on the amount of new debt that can be raised. Preferred stock explicitly embodies a liquidity option (a form of line of credit) by allowing the firm to delay reimbursement. Equity is, of course, the most accommodating claim with no precise timetable for the payment of dividends.

Second, corporations do not invest all their resources in profitable, long-term projects. They also invest in less profitable liquid assets that are held on their balance sheets as buffers against shocks. We define a liquid asset as one that the firm can quickly resell or pledge as collateral at its true value and whose market value is unlikely to be depressed when the firm needs resources. Looking at this dual condition, we observe that the first part is just the notion of liquidity emphasized in the literature on market microstructure. The second part is the analog of the covariance condition in the consumption CAPM model stemming from the producers' demand for liquidity [see Holmstrom-Tirole (1998a) for the derivation of liquidity premia in this context and a discussion of how they differ from risk premia in a consumption-based asset pricing model]. The firm's demand for a liquid asset depends on whether and how much the asset will deliver when the firm needs cash. In this respect, corporate equity or commercial real estate may be poor instruments for securing liquidity even when they are liquid in the sense of market microstructure theory. Short-term treasury bonds better satisfy our two conditions as do cash instruments, of course.

Rather than hoarding liquidity themselves, corporations may secure lines of credit from financial institutions.(1) For example, they can contract with a bank or an insurance company for the right to draw a specified amount of cash at a given rate of interest by a given date in exchange for an upfront commitment fee. The associated liability for the financial institution must be backed up by an increase in its liquid assets, sufficient to make it likely that it can deliver on its promise. Liquidity provision is an important activity of banks. For example, roughly 80 percent of commercial and industrial loans at large U.S. banks are take-downs under loan commitments (Greenbaum and Takor 1995).

Third, corporations engage in risk management. They can use derivatives to hedge specific risks (interest rate, currency, raw materials, etc.). For example, a corporation with substantial exports may quickly become short of cash if the exchange rate suddenly turns unfavorable. Foreign exchange swaps allow the firm to insure against this type of liquidity shortage. Using derivatives and forward and futures markets is only one of many ways in which firms can cover themselves against specific risks: other ways include securitization, insurance against theft, fire or the death of a key employee, trade credit insurance and diversification of various sorts (geographic, product mix, etc.).

Last, corporations also attempt to measure their global risk exposure. Sophisticated tools, such as RAROC or Risk Metrics, give an imperfect, but useful picture of a firm's or bank's exposure to various macroeconomic factors. Such Value at Risk (VAR) models, extensively used by banks to control their dealers' and traders' risk taking, and by prudential regulators to monitor banks, estimate the extreme lower tail risk of a portfolio. …

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