Liquidity Mismatch Measurement

Policymakers and academics recognize that liquidity is central in the dynamics of a financial crisis, and that measurement of liquidity is critical in evaluating and regulating systemic risk. Systemic risk depends primarily on the endogenous response of market participants to extreme events. The liquidity measure is a key response indicator and aggregate liquidity measures are important to detect a build-up of systemic risk in the background during a run-up phase. The purpose of this chapter is to examine the measurement of liquidity in light of the academic research on liquidity. What is the practical and measured counterpart of the theoretical concept of liquidity suggested by models? If one is interested in a liquidity measure that is informative about systemic risk, what measure does the academic research suggest? We discuss a liquidity (risk) measure that is computed conditional on stress scenarios. For each stress scenario and for each asset and liability a cash equivalent dollar value is assigned. The dollar values are aggregated to form a liquidity mismatch index at the level of a firm. The chapter discusses how this metric can be used to gauge systemic risk.