Lecture 9: Liquidity risk I

Which of the following most accurately captures the nature of liquidity risks in financial institutions?

• The probability that a financial institution becomes insolvent due to credit deterioriation

• The exposure to losses from being unable to meet short-term obligations or convert assets without significant discounts

• The likelihood that fluctuations in interest rates impair long-term profitability

• The risk of declining capital adequacy ratios due to macroeconomic pressures

A financial institution is unable to convert its high-quality assets into cash without incurring severe valuation losses during a crisis. What type of risk is this indicative of?

• Funding liquidity risk

• Market liquidity risk

• Capital structure risk

• Operational liquidity drag

Which situation best reflects funding liquidity risk in a systemically important bank?

• The ability to dispose treasury bonds at fair market value

• A sudden surge in interbank rates rendering rollover borrowing challenging

• a decline in Tier 1 capital ratio

• A credit downgrade due to poor asset quality

Answer explanation

A systemically important = a financial institution whose failure could trigger a widespread disruption due to size and connectedness with other financial institutions etc.

During the COVID-19 market panic, even U.S Treasuries became illiquid. This situation most clearly illustrates that

• All asset classes are equally susceptible to price volatility

• Perceived safety of an asset does not eliminate exposure to market liquidity breakdowns

• Counterparty credit risk increases during public health crises

• The duration of bonds becomes less relevant in low-rate environments.

Which of the following is an internal factor influencing liquidity risk?

• Central bank regulation

• Market sentiment

• Asset-liability mix

• Political instability

Which of the following best explains why a bank may face insolvency despite reporting positive earnings and capital adequacy?

• A decline in credit spreads triggers a capital reserve shortfall

• Interest income is offset by unrealized mark-to-market losses

• The bank's illiquid assets prevents it from meeting immediate outflows

• A significant drop in investor confidence leads to rapid deposit withdrawals.

Answer explanation

The answer D is tempting but it is not the best answer - While a loss of confidence can trigger withdrawals (a bank run), the core reason the bank fails is because it lacks sufficient liquid assets to meet those outflow. Option D is a trigger, not the core constraint that causes insolvency

Which of the following is an external liquidity driver that cannot be managed internally by a bank's treasury unit?

• Portfolio mix of loans and securities

• Customer concentration within a specific industry

• Macroprudential tightening and shifts in investor sentiments

• Liquidity stress testing policy

A key strategic advantage of relying on purchase liquidity is that it:

• Permanently lowers the cost of capital

• Allows efficient deployment of capital by minimizing idle reserves

• Eliminates liquidity transformation risk

• Reduces exposure to regulatory funding restrictions

Horizon Bank relies on commercial paper issuance for liquidity. When inflation fear arise and market participants become risk-averse, what is the most likely liquidity outcome?

• Lower borrowing costs due to increased central bank intervention

• Strengthened liquidity position due to wider investor base

• Increased refinancing risk due to rising spreads and refusal to roll over debt

• Enhanced profitability due to improved yield spreads

The primary risk of an overreliance on purchased liquidity in stressed markets:

• Regulatory arbitrage

• Escalating rollover risk that undermines funding stability

• Increasing the marginal yield on asset portfolios

• Systemic contagion from falling credit spreads