Short Introduction of Liquidity Risk and Liquidity Risk Management & Washington Mutual Bank's Collapse (wamu)

1. Short Introduction of liquidity risk and liquidity risk management (LRM)

Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. Most of the banks are vulnerable to liquidity risk due to their primary role which is maturity transformation of the short-term deposits into long-terms loans.

Since banks are affected by the uncertainty of external events, effective LRM can help to ensure a bank’s ability to meet cash flow obligations. It is crucial that all banks incorporate a LRM framework as a liquidity shortfall to a single financial institution might cause a “domino” effect as all institutions are inter-connected and interdependent. Moreover, for the past decade, the complexity of liquidity risk and its management have increased due to developments of the financial market which increases the importance of LRM.  

1. 2007 financial market crisis

At the onset of the financial market crisis in 2007, many banks had adequate capital levels but they still ended up experiencing serious difficulties when it came to LRM, in which failing to sufficiently account for their exposure to liquidity risk.

Before the crisis, the liquidity for funding purposes was readily available and plentiful and most of the banks think that the markets were safe which results in many banks to fail in taking account of a number of basic principles of LRM. Also, banks viewed funding of these obligations as nearly impossible and many banks had not considered the amount of liquidity they might need to meet all these obligations.

However, the financial market crisis resulted in cheap funding to manage the liquidity to evaporate rapidly and that illiquidity can last for an extended period of time. This resulted in many banks’ failure. One of the bank that collapsed was Washington Mutual Bank.

1. Case study: Washington Mutual Bank's Collapse (WaMu)

1.  Causes of WaMu’s Failure: 

WaMu’s failure was due to their management goals of a highly risky lending strategy. Combined with their subpar underwriting standards and insufficient risk controls, WaMu strategy finally broke down in mid-2007 when the housing and mortgage market collapsed. WaMu is slapped with loan losses, borrowing capacity limits and a grim stock price. In September 2008, WaMu’s depositors started to withdraw which was sparked by rumors of WaMu’s problems and other prominent failures. WaMu’s inability to solve the liquidity issue led to its imminent collapse