3.0 Liquidity risk challenges and management strategies

3.1 Liquidity risk: the great balancing act

Liquidity risk has re-emerged as a central vulnerability for financial institutions, driven by rapid information flows (fuelled by social media), geopolitical shocks, and evolving funding markets.

During RiskMinds International, risk leaders urged institutions to embed holistic, forward-looking liquidity and risk management into their practices. These must emphasise resilience, adaptability and reputational strength; not only balancing sheet optimisation.

Institutions are vulnerable to collapse, not due to solvency issues alone, but because of the speed and scale of liquidity withdrawal. This vulnerability is profoundly exacerbated by the modern, interconnected environment. Concentrated depositors have access to instant digital communication. This enables them to trigger bank runs that are exponentially faster than historical precedents. The failure to model this accelerated behavioural response represents a fundamental gap in conventional risk frameworks.

Recent bank failures such as Credit Suisse and Silicon Valley Bank highlight the primacy of liquidity over capital in crisis situations.

The case of Silicon Valley Bank serves as a definitive data point.

The institution exposes itself to significant duration risk through unhedged, long-dated asset investments, a decision driven by a focus on short-term profitability at the expense of prudent risk management. Compounding this structural imbalance was a severe concentration risk within its depositor base and a critical lapse in governance; notably the absence of a CRO.

This scenario echoes historical crises, such as the Long-Term Capital Management (LTCM) failure, where a long-term strategic focus is pursued at the perilous expense of short-term liquidity and an underestimation of systemic risk contagion.

If you are distracted, you have concentration risk, you fail to see the short term vulnerabilities, then you expose yourself. And even if you have a great strategic prospect, you can shoot yourself in the foot.

Head of Risk and Compliance, Scandinavian investment company

3.2 Holistic Asset-Liability Management (ALM) frameworks

A central imperative for financial institutions is the adoption of a truly holistic and integrated Asset–Liability Management (ALM) framework, reflecting the reality that treasury and short-term funding can no longer be managed in isolation.

Effective liquidity management now requires a consolidated view that explicitly links interest rate dynamics, the quality and composition of the credit book, and the market risk embedded in funding activities.

Stress signals in funding markets, such as repo rates, illustrate how liquidity access is shaped not only by pricing mechanics but by counterparty perceptions, collateral quality, and institutional reputation.

These dynamics underscore that non-financial factors can have immediate and material financial consequences, necessitating a shift away from siloed treasury functions toward an integrated ALM approach that incorporates credit quality, behavioural assumptions, and funding dependencies across both banking and non-banking activities.

You've got to look at liquidity risk from a holistic view and make sure you have an integrated asset liability management system that can take a view on the quality of your credit book, on the dynamics of your rates, as well as on the market risk embedded in your short term funding activities.

Group CRO, Italian financial conglomerate

Financial institutions must elevate liquidity resilience as a strategic imperative. Boards and CRO's should:

1) Review current ALM frameworks to incorporate digital-era behavioural assumptions and the impact of concentrated funding.

3.3 Strategic imperatives for leadership

2) Move beyond rigid scenario planning to conduct training that emphasises adaptable responses and empowers teams to deviate from pre-determined playbooks when necessary.

3) Ensure the maintenance of robust collateral buffers and diversified funding sources, proactively signalling strength through pre-emptive capital and collateral positioning to safeguard against the next liquidity test.

3.4 Liquidity, concentration and wrong-way risk

One important aspect of liquidity management is wrong-way risk, where a counterparty’s probability of default is positively linked to the value of the underlying portfolio; that is, the counterparty is most likely to default precisely when the bank’s exposure to it is largest. The defining feature of wrong-way is conditionality. While it does not change how large market moves can be, in general, it materially increases the likelihood that severe market moves occur given that the counterparty has defaulted. In effect, losses that appear extreme or low-probability on an unconditional basis become expected outcomes once default is taken as the conditioning event.

The collapse of Archegos in 2021, which led to $10 billion in losses with Credit Suisse, in particular, being severely impacted, was used as a case study to illustrate the consequences of wrong-way risk.

In a presentation by a Global Head of XVA & Counterparty Credit Risk Modelling at a major investment bank, it was noted that headline stress scenarios (circa 30% equity declines) were directionally appropriate for the Archegos portfolio, they were calibrated too close to the centre of the loss distribution. For concentrated portfolios, material losses sit far deeper in the tail: moves that appear extreme at the 95th percentile are routine beyond the 99th.

More consequentially, liquidity risk dominated realised losses. Roughly half of total losses occurred after default, during portfolio unwind. Forced liquidation volumes exceeded average daily trading volumes by orders of magnitude, creating self-reinforcing price impact.

The actual loss of the Credit Suisse portfolio was around $5.5 billion, way above any of the risk metrics that were calculated in advance. So the question really is, Why? Why were these metrics inadequate?

Global Head of XVA & Counterparty Credit Risk Modelling, major investment bank

3.5 Conditioning on default changes the risk picture

Standard risk measures (margin, PFE) typically assess losses unconditionally. However, capital, CVA and economic loss are driven by exposure conditional on default. Once this conditioning is applied, outcomes that appear “once-in-a-century” become expected values.

Empirically, incorporating wrong-way risk into Archegos-calibrated models increased potential future exposure by an order of magnitude and shifted expected exposure from immaterial to economically decisive.

The uncomfortable implication for risk governance is that better-rated counterparties can warrant larger conditional stress assumptions, because their default implies a far worse underlying state of the world.

3.6 A governance problem

disguised as a modelling gap

The Archegos episode was not a failure to imagine extreme market moves; it was a failure to integrate concentration, liquidity and wrong-way risk into a single, conditional view of loss. Existing frameworks treated these effects in isolation, relied on unconditional distributions, and implicitly assumed orderly unwinds.

For CROs, the lesson is clear: counterparty risk cannot be managed by percentile-based metrics alone. It requires explicit conditioning on default, dynamic liquidity assumptions, and a willingness to accept that the most damaging risks are those that only materialise together.