Liquidity Risk Management with Cash Flow Models

This chapter is focused on the now more than ever important topic of funding liquidity risk. Liquidity risk is often a consequential risk but can by itself lead to insolvency. Our focus is on quantitative methods that are not just for risk measurement but also key to risk hedging and optimal decision making. This chapter discusses both the rationale and the practice of scenario-based approaches to liquidity and how liquidity risk can be measured and managed. The use of advanced analysis and optimization techniques for liquidity hedging and structural liquidity planning is an emerging core activity in banks that we discuss in depth. While liquidity risk measurement and allocation is usually more complex than the same for market and credit risk it can still be achieved. The allocation of liquidity risk is of significant importance in creating pricing incentives. The chapter ends with a discussion of recent regulatory developments.