Illiquidity Component of Credit Risk
by Stephen Morris of Princeton University, and
Abstract: 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. We provide a formula for illiquidity risk and show that it is (i) decreasing in the "liquidity ratio" - the ratio of realizable cash on the balance sheet to short term liabilities; (ii) increasing in the "outside option ratio" - a measure of the opportunity cost of the funds used to roll over short term liabilities; and (iii) increasing in the "fundamental risk ratio" - a measure of ex post variance of the asset portfolio.
Related reading: Dynamic Bank Runs