Berkeley Program in Law and Economics

Some trends in global funding markets are leading to a new paradigm about liquidity risk in issuers: increased cross-border debt and equity flows; the growth of equity intermediaries like private funds, sovereign wealth funds, and “club” consortia; and the use of financial products which embed contingent liabilities in firms, liabilities which “spring” into maturity in market downturns. Working together, national regulators are moving towards an enterprise – rather than entity – view of liquidity risk and making clearer distinctions between market liquidity risk (to assets) and funding liquidity risk (to obligors). Current surges of commercial liquidity make this a timely issue for issuers (liquidity consumers), prospective investors and creditors (liquidity providers), and national regulators with system responsibilities for financial public goods, like the funding markets. Creative conflicts between the interests of issuers, investor and lenders, and regulators are a healthy part of a financial system, but this paper argues for more financial literacy about funding liquidity risk. After explaining this concept, the paper situates “event risk” in the context of funding liquidity. Recent bondholder losses in leveraged restructurings of firms (“event risk”) have raised questions about whether bond indenture covenants provide adequate protection against the risk of these losses. This paper argues that funding liquidity risk and its management are important aspects of event risk, which liquidity covenants might help to mitigate for issuers and others.