Illiquidity Component of Credit Risk
23 Pages Posted: 2 Jun 2016
Date Written: May 31, 2016
We describe and contrast three different measures of an institution's credit risk. "Insolvency risk" is the conditional probability of default due to deterioration of asset quality if there is no run by short term creditors. "Total credit risk" is the unconditional probability of default, either because of a (short term) creditor run or (long run) asset insolvency. "Illiquidity risk" is the difference between the two, i.e., the probability of a default due to a run when the institution would otherwise have been solvent. We discuss how the three kinds of risk vary with balance sheet composition. Illiquidity risk is (i) decreasing in the "liquidity ratio" - the ratio of realizable cash on the balance sheet to short term liabilities; (ii) decreasing in excess return to debt; and (iii) increasing in the solvency uncertainty - a measure of ex post variance of the asset portfolio. Increasing the liquidity ratio has decreasing returns to reducing illiquidity risk.
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