Liquidity and Risk Management

This paper provides a model of the interaction between risk-management practices and market liquidity. Our main finding is that a feedback effect can arise. Tighter risk management leads to market illiquidity, and this illiquidity further tightens risk management. Risk management plays a central role in institutional investors’ allocation of capital to trading. For instance, a risk manager may limit a trading desk’s one-day 99 percent value at risk (VaR) to $1 million. This means that the trading desk must choose a position such that, over the following day, its value drops no more than $1 million with 99 percent probability. Risk management helps control an institution’s use of capital while limiting default risk, and helps mitigate agency problems. Phillipe Jorion (2000, xxiii) states that VaR “is now increasingly used to allocate capital across traders, business units, products, and even to the whole institution.” We do not focus on the benefits of risk management within an institution adopting such controls, but, rather, on the aggregate effects of such practices on liquidity and asset prices. An institution may benefit from tightening its risk management and restricting its security position, but as a consequence it cannot provide as much liquidity to others. We show that, if everyone uses a tight risk management, then market liquidity is lowered in that it takes longer to find a buyer with unused risk-bearing capacity, and, since liquidity is priced, prices fall. Search-and-Matching Financial MarketS