Overview of Financial Risks and Regulatory Frameworks › Key Parameters

The key parameters for the Expected Loss model each serve a distinct purpose in quantifying credit risk:

• PD: Probability of Default. The likelihood that a borrower defaults over a given time horizon, typically one year. PD is usually estimated from historical default rates by credit rating, from statistical models (such as Merton's structural model or logistic regression), or inferred from market prices like credit default swap spreads.
• LGD: Loss Given Default. The fraction of exposure lost if a default occurs, calculated as (1 - Recovery Rate). LGD depends on factors such as collateral quality, seniority of the claim, industry characteristics, and the economic environment at the time of default. Secured loans typically have LGDs of 30-50%, while subordinated unsecured debt may have LGDs of 70-90%.
• Exposure_M: Exposure at Default (EAD). The total value exposed to credit loss at the time of default (in millions). For term loans, EAD equals the outstanding balance. For revolving credit facilities, EAD must account for additional draws that borrowers typically make as they approach default.

Liquidity risk is the potential for losses arising from the inability to meet payment obligations or to exit positions without incurring unacceptable costs. Unlike market risk, which relates to price movements, liquidity risk relates to the ability to transact at reasonable prices, or to transact at all. An asset might have a well-defined market price, but if you cannot sell it at that price when you need to, the quoted price provides little comfort.

Liquidity risk is often described as a "meta-risk" because it amplifies other risks. A position that would be manageable if you could exit it becomes dangerous when exit is impossible or prohibitively expensive. This amplification effect means that liquidity considerations should infuse all aspects of risk management, not exist as a separate category considered in isolation.

Liquidity risk has two distinct but related dimensions:

• Funding liquidity risk: The risk that a firm cannot meet its payment obligations when due, whether through cash, borrowing, or asset sales. A firm might be solvent on a mark-to-market basis but still face a liquidity crisis if it cannot roll over short-term debt. The classic example is a bank run: depositors demanding withdrawal simultaneously forces the bank to liquidate assets at fire-sale prices, potentially causing insolvency even if the bank was initially solvent.
• Market liquidity risk: The risk that a firm cannot exit positions without moving the market price significantly against itself. A fund holding large positions in small-cap stocks may find that selling quickly requires accepting substantial price discounts. Market liquidity risk increases with position size relative to typical trading volume and varies dramatically across asset classes and market conditions.

These two forms of liquidity risk can interact dangerously, creating what economists call a "liquidity spiral." In a crisis, funding becomes scarce precisely when assets become illiquid. Institutions forced to sell illiquid assets to meet margin calls push prices down further, triggering more margin calls and more forced selling, creating a feedback loop that amplifies market dislocations far beyond what fundamentals would justify.

We can visualize the liquidity spectrum by comparing bid-ask spreads and liquidation times across different asset classes.