Putting Liquidity Risk Management into a Wider Context

In this chapter we put liquidity risk management in the wider context of the financial system. We discuss how liquidity risk can be a driving force of systemic risk, by connecting macro- and microprudential liquidity risk. Here, endogeneity, bank behaviour and second-round effects play an important role. We highlight the necessity to take into account the wider context in both banks’ internal frameworks of liquidity risk management and in supervision. In particular, we provide an – albeit cursory – overview of the relevant systemic dynamics that can have a strong amplifying effect on the liquidity situation of a bank and a banking system: the endogeneity of liquidity (systemic liquidity), the role of the central bank, the macrofinancial environment and the interaction between liquidity and solvency risk. Our focus will be on the Eurosystem but the general dynamics hold elsewhere as well. While the integration of these considerations into bank and supervisory models of liquidity risk is in the early stages of development, we show that a narrow focus on traditional risk management models is likely to lead to a false sense of security and eventually a rude awakening.