Liquidity What do we know Christian Upper Bank
Liquidity: What do we know? Christian Upper Bank for International Settlements 1
Plan of the talk l Different concepts of liquidity l Central bank and BIS work on liquidity l Liquidity black holes and what can be done to prevent them l Research agenda on liquidity l Disclaimer: The views expressed in this presentation are my own and do not necessarily reflect those of the Bank for International Settlements. 2
What is liquidity? The ability to trade immediately and at prices that are only affected by expected return and risk considerations Market liquidity: ability to transform financial assets into cash at current market prices Balance sheet liquidity: cash holdings Funding liquidity: ability to convert assets into cash Macroeconomic liquidity: the availability of cash in the economy 3
Starting point: 1998 market turbulences Effective bid/ask spreads of German benchmark bond 4
Follow up work by central banks and BIS l CGFS post mortem l CGFS working group on market liquidity l BIS workshop on market liquidity, August 2000 l BIS autumn economist meeting on market functioning and central bank action, October 2001 l Research papers at central banks and BIS 5
Follow up work by central banks and BIS l Almost exclusively focused on market liquidity l Good at finding empirical regularities, but less successful in identifying underlying mechanism l Few attempts to link market liquidity to other notions of liquidity 6
Linking the different concepts of liquidity Market liquidity l close substitutes Balance sheet liquidity l Complements (on an aggregate basis) Macroeconomic liquidity Funding liquidity 7
Linking the different concepts of liquidity Market liquidity Balance sheet liquidity Northern Rock Macroeconomic liquidity Funding liquidity 8
Linking the different concepts of liquidity Market liquidity Balance sheet liquidity l precondition for provision of market liquidity l Non-linearities due to leverage Macroeconomic liquidity Funding liquidity 9
Linking the different concepts of liquidity Market liquidity l Liquidity supplied by CB held by banks l Low interest rates reduce opportunity cost of holding cash Macroeconomic liquidity Balance sheet liquidity Funding liquidity 10
Linking the different concepts of liquidity Market liquidity Balance sheet liquidity l Loose credit standards increases funding liquidity Macroeconomic liquidity Funding liquidity 11
Linking the different concepts of liquidity Market liquidity Balance sheet liquidity l Market liquidity precondition for repo market Macroeconomic liquidity Funding liquidity 12
Linking the different concepts of liquidity Market liquidity Balance sheet liquidity l Summer 2007: concerns about credit risk wipe out market liquidity Macroeconomic liquidity Funding liquidity 13
Linking the different concepts of liquidity l Different concepts of liquidity closely related. . . l … but relationship far from straightforward l Liquidity can suddenly vanish (“liquidity black hole”) • 1994 bond market sell-off • 1998 LTCM crisis • 2007 sell-off l Disruptions in one type of liquidity could cause disruptions in other types 14
Characteristics of liquidity crises l Asset price volatility l Distress selling l Defaults Liquidity risk may suddenly transform into solvency risk 15
Understanding liquidity crises l Literature on relationship between market liquidity and volatility focuses mainly on normal states of the world l Sizable literature on distress selling (surveyed by Shim & von Peter (2007)) l But only little work on relationship between liquidity and counterparty risk • Müller (2006): simulates how unwinding of interbank lending can lead to solvency problems 16
Crisis management l Lender of last resort versus market maker of last resort 17
Preventing liquidity crises l Often triggered by seemingly minor events: • 1994 bond market sell-off: surprise Fed tightening • 1998 LTCM: Russian default, breakdown of apparently arcane pricing relationships • 2007 sell-off: US subprime housing, associated loss of confidence in ratings and other basic rules of the game Suggests that liquidity is a self-fulfilling phenomenon 18
Preventing liquidity crises l Is liquidity always self-fulfilling? l Or are there parameter constellations under which liquidity is more fragile than under others? l Starting point: liquidity crises often follow periods of financial overextension (“boom-bust cycles”) 19
Boom-bust cycles 1. Positive fundamental shock catches investors’ imagination 2. Asset prices increase 3. Increased appetite for risk, higher leverage 4. Asset prices increase further than warranted by fundamentals Facilitating factors: l Amnesia l Excess macroeconomic liquidity 20
Boom-bust cycles l Inadequate literature on boom-bust cycles l Some narrative work: • Minski, Kindleberger • Borio (2004) links this to liquidity l But not much formal modeling and even less rigorous empirical testing 21
Preventing liquidity crises l How to ensure market participants take into account liquidity risk when taking decisions? • Capital requirements for liquidity risk • Ensure diversity of models • Impose longer horizons on models, use longer datasets for backtesting • Require stress testing with real stress scenarios 22
Preventing liquidity crises l But success ultimately depends on management’s willingness to forego short-term gain for longer-term stability l Role of monetary policy 23
A research agenda on liquidity l Theoretical work linking different concepts of liquidity Hypotheses for rigorous empirical testing l Models of boom-bust cycles l Work on relationship between liquidity and solvency 24
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