Liquidation Risk

Turmoil in financial markets is often accompanied by a significant decrease in market liquidity. Here, we investigate how such key risk measures as likelihood of insolvency, value at risk, and expected tail loss respond to bid– ask spreads that are likely to widen just when positions must be liquidated to maintain capital ratios. Our results show that this sort of illiquidity causes significant increases in risk measures, especially with fat-tailed returns. A potential strategy that a financial institution may adopt to address this problem is to sell illiquid assets first while keeping a “cushion” of cash and liquid assets for a “rainy day.” Our analysis demonstrates that, although such a strategy increases expected transaction costs, it may significantly decrease tail losses and the probability of insolvency. In light of our results, we recommend that financial institutions carefully examine their strategies for liquidation during periods of severe stress.