liquidity what do we know

8/6/2019 Liquidity What Do We Know

http://slidepdf.com/reader/full/liquidity-what-do-we-know 1/24

1

Liquidity: What do we know?

Christian Upper

Bank for International Settlements

1



2

Plan of the talk

Different concepts of liquidity

Central bank and BIS work on liquidity Liquidity black holes and what can be done to prevent them

Research agenda on liquidity

Disclaimer: The views expressed in this presentation are

my own and do not necessarily reflect those of the Bank for

International Settlements.



3

What is liquidity?

The ability to trade immediately and at prices that are only

affected by expected return and risk considerationsMarket 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



4

Starting point: 1998 market turbulences

Effective

bid/askspreads of

German

benchmark

bond



5

Follow up work by central banks and BIS

CGFS post mortem

CGFS working group on market liquidity BIS workshop on market liquidity, August 2000

BIS autumn economist meeting on market functioning and

central bank action, October 2001

Research papers at central banks and BIS



6

Follow up work by central banks and BIS

Almost exclusively focused on market liquidity

Good at finding empirical regularities, but less successfulin identifying underlying mechanism

Few attempts to link market liquidity to other notions of

liquidity



7

Linking the different concepts of liquidity

Market

liquidity

Balance

sheet

liquidity

Funding

liquidityMacroeconomic

liquidity

close substitutes

Complements (on an

aggregate basis)



8


Market

liquidity

Balance

sheet

liquidity

Funding


liquidity

Northern Rock



9


Market

liquidity

Balance

sheet

liquidity

Funding


liquidity

precondition for

provision of

market liquidity

Non-linearities due

to leverage



10


Market

liquidity

Balance

sheet

liquidity

Funding


liquidity

Liquidity supplied by

CB held by banks

Low interest rates

reduce opportunity

cost of holding cash



11


Market

liquidity

Balance

sheet

liquidity

Funding


liquidity

Loose credit

standards

increases funding

liquidity



12

Market

liquidity

Balance

sheet

liquidity

Funding


liquidity

Market liquidity

precondition for

repo market




13

Market

liquidity

Balance

sheet

liquidity

Funding


liquidity

Summer 2007:

concerns about

credit risk wipe out

market liquidity




14

Different concepts of liquidity closely related ...

« but relationship far from straightforward Liquidity can suddenly vanish (³liquidity black hole´)

� 1994 bond market sell-off

� 1998 LTCM crisis

� 2007 sell-off

Disruptions in one type of liquidity could cause disruptions

in other types




15

Asset price volatility

Distress selling Defaults

Liquidity risk may suddenly transform into solvency risk

Characteristics of liquidity crises



16

Literature on relationship between market liquidity and

volatility focuses mainly on normal states of the world Sizable literature on distress selling (surveyed by Shim &

von Peter (2007))

But only little work on relationship between liquidity and

counterparty risk

� Müller (2006): simulates how unwinding of interbank

lending can lead to solvency problems

Understanding liquidity crises



17

Lender of last resort versus market maker of last resort

Crisis management



18

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

Preventing liquidity crises



19

Is liquidity always self-fulfilling?

Or are there parameter constellations under which liquidityis more fragile than under others?

Starting point: liquidity crises often follow periods of

financial overextension (³boom-bust cycles´)




20

1. Positive fundamental shock catches investors¶ imagination

2. Asset prices increase3. Increased appetite for risk, higher leverage

4. Asset prices increase further than warranted by

fundamentals

Facilitating factors: Amnesia

Excess macroeconomic liquidity

Boom-bust cycles



21

Inadequate literature on boom-bust cycles

Some narrative work:� Minski, Kindleberger

� Borio (2004) links this to liquidity

But not much formal modeling and even less rigorous

empirical testing

Boom-bust cycles



22

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




23

But success ultimately depends on management¶s

willingness to forego short-term gain for longer-termstability

Role of monetary policy




24

Theoretical work linking different concepts of liquidity

Hypotheses for rigorous empirical testing Models of boom-bust cycles

Work on relationship between liquidity and solvency

A research agenda on liquidity

liquidity what do we know

Documents