Dear SAP Banking Community members.
A common definition of liquidity risk, is the risk that an asset cannot be traded quickly enough in the market, to prevent a loss or make the required profit.
Insufficient liquidity can kill a bank very quickly, but excess of liquidity prevents the bank from making efficient use of its capital and limits its profit.
Banks are aware of the importance of liquidity planning, but unfortunately they lack sometimes on evaluating how liquidity risk is deeply related to other forms of risk, like credit or market risk.
For instance, if a bank has a position in an illiquid asset, its limited ability to liquidate that position at short notice, will affect its market risk management.
A very good example of this relationship, is the event known as the "Metallgesellschaft debacle" in 1994.
Metallgesellschaft AG was formerly one of Germany's largest industrial conglomerates based in Frankfurt. It had over 20,000 employees and revenues in excess of 10 billion US dollars.
During 1992 and 1993, Metallgesellschaft succeeded in signing a large number of long-term contracts for the delivery of gasoline to independent retailers.
The company had no competitive advantages in its costs of supply; so the company executives defined a marketing strategy, based on offering to the retailers a fix price (protecting them from increases on the energy prices).
Additionally, they tried to hedge the company results to rises on energy prices by taking long positions on the energy market. Unfortunately, instead of using similar maturities for the long and short positions, they sell long term contracts and buy short term derivatives.
But the energy prices fall in 1993 generating unrealized losses, and for making it worse, the futures market went into a contango price relationship for almost entire year, increasing cost each time they rolled its derivatives (which were short term, not matching the long term delivery contracts with their retailers).
Initially it would look like, that the problem was their hedging strategy didn´t work; when in fact, the root cause was the maturity mismatch between their short and long positions on the energy price (liquidity risk).
At the end of 1993, the company had lost over 1.4 billion dollars.
Additionally the company was exposed to a credit risk by signing long term contracts with the retailers, which probably couldn´t have kept their obligations in the long term, if the prices had remained low, as they agreed a fixed price with Metallgesellschaft.
The situation is more interesting, when we analyze the reason why the company managers "made" the mistake, of not buying their derivatives with the same maturity of their sales contracts. Mainly, because no bank wanted to accept the credit risk of a long term contract with Metallgesellschaft.
This is just an example of a non financial organization, which operating in one single market, and even trying to hedge the market risk, they failed to do it, for not managing all the risks in an integrated way.
What can be the risk exposures of diversified Financial Institutions, operating in different markets, if they make the same mistake?
Looking forward to read your opinions.
Kindest Regards.
Ferran.
A common definition of liquidity risk, is the risk that an asset cannot be traded quickly enough in the market, to prevent a loss or make the required profit.
Insufficient liquidity can kill a bank very quickly, but excess of liquidity prevents the bank from making efficient use of its capital and limits its profit.
Banks are aware of the importance of liquidity planning, but unfortunately they lack sometimes on evaluating how liquidity risk is deeply related to other forms of risk, like credit or market risk.
For instance, if a bank has a position in an illiquid asset, its limited ability to liquidate that position at short notice, will affect its market risk management.
A very good example of this relationship, is the event known as the "Metallgesellschaft debacle" in 1994.
Metallgesellschaft AG was formerly one of Germany's largest industrial conglomerates based in Frankfurt. It had over 20,000 employees and revenues in excess of 10 billion US dollars.
During 1992 and 1993, Metallgesellschaft succeeded in signing a large number of long-term contracts for the delivery of gasoline to independent retailers.
The company had no competitive advantages in its costs of supply; so the company executives defined a marketing strategy, based on offering to the retailers a fix price (protecting them from increases on the energy prices).
Additionally, they tried to hedge the company results to rises on energy prices by taking long positions on the energy market. Unfortunately, instead of using similar maturities for the long and short positions, they sell long term contracts and buy short term derivatives.
But the energy prices fall in 1993 generating unrealized losses, and for making it worse, the futures market went into a contango price relationship for almost entire year, increasing cost each time they rolled its derivatives (which were short term, not matching the long term delivery contracts with their retailers).
Initially it would look like, that the problem was their hedging strategy didn´t work; when in fact, the root cause was the maturity mismatch between their short and long positions on the energy price (liquidity risk).
At the end of 1993, the company had lost over 1.4 billion dollars.
Additionally the company was exposed to a credit risk by signing long term contracts with the retailers, which probably couldn´t have kept their obligations in the long term, if the prices had remained low, as they agreed a fixed price with Metallgesellschaft.
The situation is more interesting, when we analyze the reason why the company managers "made" the mistake, of not buying their derivatives with the same maturity of their sales contracts. Mainly, because no bank wanted to accept the credit risk of a long term contract with Metallgesellschaft.
This is just an example of a non financial organization, which operating in one single market, and even trying to hedge the market risk, they failed to do it, for not managing all the risks in an integrated way.
What can be the risk exposures of diversified Financial Institutions, operating in different markets, if they make the same mistake?
Looking forward to read your opinions.
Kindest Regards.
Ferran.
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