Introduction

In this chapter, we will delve into the critical concept of funding liquidity risk by examining notable financial disasters associated with institutions such as Lehman Brothers, Continental Illinois, and Northern Rock. Funding liquidity risk arises when an institution faces challenges in obtaining the necessary funds to meet its financial obligations. We will analyze the key factors that led to these financial disasters and derive valuable lessons that can help organizations better manage and mitigate funding liquidity risks.

Lehman Brothers

The case of Lehman Brothers serves as a stark reminder of the dangers posed by funding liquidity risk. In 2008, Lehman Brothers faced a severe liquidity crisis that ultimately led to its bankruptcy. The firm’s heavy reliance on short-term borrowing to finance its long-term assets exposed it to a liquidity mismatch. When the market sentiment turned negative, Lehman Brothers struggled to roll over its short-term debt, leading to a sudden and catastrophic funding shortfall. The inability to secure funding triggered a chain reaction, eroding investor confidence and triggering a widespread financial crisis.

Continental Illinois

The Continental Illinois National Bank and Trust Company case highlights the importance of adequate risk assessment in managing funding liquidity risk. In the 1980s, Continental Illinois faced a run on deposits due to concerns about its exposure to energy-related loans. The bank’s aggressive lending practices had left it vulnerable to declining energy prices. The resulting deposit outflows revealed the bank’s inability to access sufficient funding to maintain operations. Regulatory intervention was required to prevent a systemic collapse, illustrating the broader implications of funding liquidity risk mismanagement.

Northern Rock

The Northern Rock crisis in the United Kingdom underscored the significance of confidence and perception in liquidity risk management. In 2007, Northern Rock experienced a liquidity crisis driven by its reliance on short-term wholesale funding. As news of its liquidity troubles spread, depositors rushed to withdraw their funds, exacerbating the funding liquidity challenge. The crisis showcased how market sentiment and public perception can significantly impact an institution’s funding stability, emphasizing the need for proactive risk communication.

Lessons Learned

• Diversification of Funding Sources: Institutions should avoid over-reliance on a single source of funding, especially short-term wholesale funding. Diversifying funding sources, including longer-term financing, can enhance stability during market downturns.

• Liquidity Risk Stress Testing: Regular stress testing scenarios can help institutions assess their resilience to liquidity shocks. These tests simulate adverse scenarios, enabling institutions to identify vulnerabilities and develop effective contingency plans.

• Transparency and Communication: Maintaining open communication with stakeholders is crucial. Transparent reporting and proactive risk communication can help prevent panic-driven runs on deposits and maintain confidence in the institution.

• Risk Assessment and Management: Thoroughly assessing and managing credit and market risks associated with assets can prevent excessive exposure to adverse events that trigger liquidity crises.