Liquidation Risk

Turmoil in financial markets is often accompanied by a significant decrease in market liquidity. Here, we investigate how such key risk measures as likelihood of insolvency, value at risk, and expected tail loss respond to bid–ask spreads that are likely to widen just when positions must be liquidated to maintain capital ratios. Our results show that this sort of illiquidity causes significant increases in risk measures, especially with fat-tailed returns. A potential strategy that a financial institution may adopt to address this problem is to sell illiquid assets first while keeping a “cushion” of cash and liquid assets for a “rainy day.” Our analysis demonstrates that, although such a strategy increases expected transaction costs, it may significantly decrease tail losses and the probability of insolvency. In light of our results, we recommend that financial institutions carefully examine their strategies for liquidation during periods of severe stress. Turmoil in financial markets is often accompanied by significant decreases in market liquidity. Financial institutions that need to liquidate positions under such stress to meet capital requirements may, therefore, face unexpectedly high bid–ask spreads, thus triggering additional losses in the form of transactions costs. The result could be a vicious circle of sales causing illiquidity losses, which necessitate further sales, and so on. Although the negative correlation between bid–ask spreads and asset prices clearly has adverse effects on financial institutions, especially those with significant leverage, the magnitude and practical relevance of this phenomenon for risk management have not been assessed.We investigate the impact on key risk measures—such as the likelihood of insolvency, value at risk (VAR), and expected tail loss—of spreads that are likely to widen just when positions must be liquidated to maintain capital ratios. We consider a simple model of a leveraged financial institution that holds cash, liquid assets, and illiquid assets and that is subject to minimum capital requirements. Using a Monte Carlo analysis of 10-day trading periods, we show that negative correlation between asset prices and bid–ask spreads may cause significant increases in all of these risk measures. The relevance of this link for risk management is especially strong in the presence of fat-tailed returns, which are prevalent in many markets.We also show that high volatility in asset returns need not increase the impact of illiquidity on risk measures. Intuitively, one would expect increasing volatility to lead to more frequent asset sales and, therefore, to larger spread-induced losses. Although increasing volatility does indeed increase the relative impact of bid–ask spreads on the probability of insolvency, we find that high volatility may actually reduce the relative effect of spreads on VAR and expected tail loss.Our analysis of the effect of spread volatility shows that the relative increases in VAR and expected tail loss that are induced by correlation between spreads and asset prices are moderate. Interestingly, however, when both price and spread volatility are increased, the probability of insolvency can become dramatic, even for the short time horizons that we consider.A potential strategy to address the dangers associated with a negative correlation between market liquidity and asset prices is for a financial institution to sell illiquid assets first and keep a “cushion” of cash and liquid assets for a rainy day. According to the simple model we present, such a strategy, while increasing expected transaction costs, may significantly decrease tail losses and, especially, the probability of insolvency. This “cash-last” liquidation strategy does not, however, bring the risk of insolvency to negligible levels when asset returns and bid–ask spreads have fat tails.Our results suggest an important trade-off between the goal of minimizing expected transaction costs associated with stressed asset “fire sales” and the goal of reducing the probability of insolvency. In light of this trade-off, financial institutions would be wise to carefully examine their strategies for liquidation during periods of severe stress.