to hoard cash, making even solvent banks become illiquid overnight.<sup>3</sup> It should be noted that precautionary hoarding increases when the likelihood of liquidity shocks rises and market funds are more difficult to obtain, triggering a liquidity spiral and often cross-bank contagion.<sup>4</sup> 4. Clearly, the concept of liquidity is critical for the operation of banks in good and, even more so, in bad times, when they might face more limited access options (higher market liquidity risk) and become more dependent on central bank liquidity support. Paradoxically, prior to the present crisis the theme of liquidity management has received limited attention from both international bodies (there is no ‘Liquidity Accord’ under the auspices of the Basel Committee) and in the IMF/WB Financial Sector Assessment Program (FSAPs), where there is some limited attention focused on the lender of last resort (LOLR) facilities of central banks and payment and securities settlement systems (under the rather misleading heading of “systemic liquidity infrastructure”).<sup>5</sup> Even in the stress-testing undertaken in FSAPs, the issue of liquidity does not receive enough attention. This Working Paper aims at flagging some of the critical issues in this area to provide **practical guidance** on how to approach liquidity issues in FSAPs and other Bank/IMF work, synthesizing practical approaches from a wide number of sources.

5. Why has liquidity risk become more critical? There are two inter-related fundamental reasons: (i) a change in the traditional banking intermediation model; and (ii) increased competition. Historically, banks relied on stable and low-cost core deposits (demand, savings and time deposits) as the primary source of funding to generate a portfolio of (rather illiquid) loans held to maturity. So there is a fundamental risk, as banks are in general structurally illiquid. However, as long as liquid assets (LA) were sufficient in relation to more volatile liquid liabilities (LL), that is LA>LL, banks would in normal circumstances be fine (i.e.; liquid). More recently the availability of alternative investments and savings products offered by a wider variety of financial institutions has made the banks’ traditional funding base smaller, less predictable (i.e.; more volatile) and more costly. The adoption of an ‘originate and sell’ banking intermediation model, known as a securitized model, has induced banks to rely more and more on price and credit sensitive market funding, in general increasing the share of wholesale funding in total banking funds on the liability side, and the reliance on securitization markets on the asset side. What is really new about this crisis compared with other is the extent of (complete and incomplete) securitization.<sup>6</sup> The increased competition from other banks and non-bank financial institutions, as well by securities markets, has put additional pressure on banks’ net interest margins and has driven them to optimize liquidity management, resulting in a secular decline (see below) in lower-yielding, on balance sheet, liquid assets. The search for yield (rising returns on assets ROA- and return on equity—ROE) by shareholders and bank managers in more competitive markets induced banks to increase their leverage and take more

> 3 Roubini, R. ‘Worse than LTCM: Not just a liquidity crisis; rather a credit crisis crunch’, _RGE Monitor_ , August 2007

> 4  See Markus K. Brunnermier, “Deciphering the 2007-08 Liquidity and Credit Crunch”,  Mimeo, Princeton University, May 19, 2008.

> 5 WB-IMF, _Financial Sector Assessment: A Handbook,_ 2005.

> 6 By incomplete securitizations I mean that the selling bank still retained the liquidity risk from maturity transformations. As observed in the present crisis, even when the securitization was complete (i.e.; risks were fully off-loaded from the bank’s balance sheet), for reputational reasons and not always for legal reasons banks provided backstop liquidity facilities and credit lines. See Brunnermeier, op.cit., page 27.