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Create account Login Subscribe. Lasse Pedersen 15 November Why is it at the heart of the crisis? How can we fix it? This column explains it all in terms any trained economist can understand. What is liquidity risk and how can it help us understand the current crisis? How do we solve the crisis - and which measures will only hurt?
Here I provide some answers. To see the slides with lots of figures and graphs, click here. There are two kinds of liquidity: For instance, a levered hedge fund may lose its access to borrowing from its bank and must sell its securities as a result.
Or, from the bank's perspective, depositors may withdraw their funds, the bank may lose its ability to borrow from other banks, or raise funds via debt issues. Liquidity generally varies over time and across markets, and currently we are experiencing extreme market liquidity risk. The most extreme form of market liquidity risk is that dealers are shutting down no bids! We are also experiencing extreme funding liquidity risk since banks are short on capital, so they need to scale back their trading that requires capital, and also scale back the amount of capital they lend to other traders such as hedge funds, that is, hedge funds now face higher margins.
In short, if banks cannot fund themselves, they cannot fund their clients. The two forms of liquidity are linked and can reinforce each other in liquidity spirals where poor funding leads to less trading, this reduces market liquidity, increasing margins and tightening risk management, thus further worsening funding, and so on.
An illiquid security has a higher required return to compensate investors for the transaction costs. Since market liquidity may deteriorate when you need to sell in the future, investors face market liquidity risk as discussed above. Investors naturally want to be compensated for this, so market liquidity risk increases the required return. Indeed, the liquidity-adjusted capital asset pricing model shows how liquidity betas complement the standard market beta.
The higher required return in times of higher market liquidity risk leads to a contemporaneous drop in prices, according to this theory, consistent with what we are seeing in the current marketplace. An overview of the liquidity literature is available here. The trigger of the crisis was the bursting of the housing bubble, combined with a large exposure by the levered financial institutions. This led to significant bank losses with associated funding liquidity problems.
This started the systemic liquidity spirals. To do this, they:. This put stress on the interbank funding market as measured e. Other investors, especially those that rely on leverage such as hedge funds, face funding risk when banks become less willing to lend, they raise margins, and, in the extreme, when the banks fail as Lehman did.
When banks such as Bear Stearns and Lehman started to look vulnerable, their clients risked losing capital or having it frozen during a bankruptcy, and they started to withdraw capital and unwind positions, leading to a bank run. This funding liquidity crisis naturally lead to market illiquidity with bid-ask spreads widening in several markets, and quoted amounts being reduced by dealers with less available capital.
This market illiquidity, and the prospect of further liquidity risk, scared investors and prices dropped, especially for illiquid assets with high margins. This is the downward liquidity spiral as illustrated in the chart. The crisis has been spreading across asset classes and markets globally.
There are as traders unwind carry trades and lose faith in weak currencies. This must mean that no one can arbitrage because no one can borrow uncollateralised, no one has spare collateral, and no one is willing to lend — arbitrage involves both borrowing and lending. The increased risk and illiquidity has also lead to a spike in volatility, contributing to the higher margins. Further, correlations across assets have increased as everything started trading on liquidity.
Clearly, the crisis is having a significant effect on the real economy as homeowners see their property value deteriorate, consumers access to borrowing is reduced, main street companies face higher cost of equity and especially debt capital and a lower demand for their products, unemployment goes up, etc.
If the problem is a liquidity spiral, we must improve the funding liquidity of the main players in the market, namely the banks. Hence, banks must be recapitalised by raising new capital, diluting old equity, possibly reducing face value of old debt. This can be done with quick resolution bankruptcy for institutions with systemic risk, i. Further, we must improve funding markets and trust by broadening bank guarantees, opening the Fed's discount window broadly giving collateralised funding with reasonable margins , and ensuring the Commercial Paper market function.
Further, risk management must acknowledge systemic risk due to liquidity spirals and the regulations must consider the system as a whole, as opposed to each institution in isolation.
If we have learned one thing from the current crisis, it is that trading through organised exchanges with centralised clearing is better than trading over-the-counter derivatives because trading derivatives increases co-dependence, complexity, counterparty risk, and reduces transparency.
Said simply, when you buy a stock, your ownership does not depend on who you bought it from. In the debate about how to solve the crisis and prevent the next one, it has been suggested that policymakers should ban short selling and impose a transaction tax on stocks. I believe that neither is a good idea. First, short sellers bring new information to the market, increase liquidity, and reduce bubbles remember the housing bubble started this crisis so preventing this can be very costly and prohibiting short sales does not solve the general funding problem.
While temporarily banning new short sales of financial institutions can be justified if there is risk of predatory trading , this is rarely a good idea since short sellers are often simply scapegoats when bad firms go down fighting. See here for how shortselling works. Second, a transaction tax on stocks is problematic for several reasons, most importantly because it moves trading away from the official exchanges and into the derivatives world, thus increasing the systemic risk.
One of the main arguments in favour of such a transaction tax is that it helps to prevent bubbles, but there is little or no empirical evidence to support this. For instance, in the UK there is a 0.
Further, with a depressed and vulnerable stock market, this does not appear to be the best time to introduce transactions taxes related to potential stock price bubbles in the far future.
To see the problem, consider what happened in the UK due to their transaction tax. The professional investors such as hedge funds found a way around the regulation by executing their trades using derivatives rather than trading stocks directly while individual investors are unable to avoid the tax. Specifically, in the UK hedge funds typically trade via swaps with counterparties such as investment banks to avoid the transaction tax.
There is little doubt that this would also happen in the US if such a tax was introduced here. This would increase counterparty dependencies, systemic risk, and worsen risk management spirals as discussed above.
Another serious problem with the tax is that it lowers liquidity in the marketplace as trading activity may move abroad, move into other markets, or disappear. On top of these distortions to the stability of the financial system, this tax may raise capital costs for Main Street firms because of higher liquidity risk in US financial markets.
Indeed, buying US stocks will be less attractive to investors — domestically and internationally — if they must pay a tax to buy and if they anticipate reduced liquidity in the future when they need to sell.
This could make it harder for US corporations to raise capital. And, the importance of being able to raise capital is what this crisis is all about. Market liquidity risk is an important driver of security prices, risk management, and the speed of arbitrage.
And the funding liquidity of banks and other intermediaries is an important driver of market liquidity risk. Liquidity crisis are evolve through liquidity spirals in which losses, increasing margins, tightened risk management, and increased volatility feed on each other.
As this happens, traditional liquidity providers become demanders of liquidity, new capital arrives only slowly, and prices drop and rebound. Viral Acharya and Lasse Heje Pedersen Yakov Amihud and Haim Mendelson Brunnermeier and Lasse Heje Pedersen Brunnermeier and Lasse Heje Pedersen. Nicolae Garleanu, and Lasse Heje Pedersen Liquidity risk and the current crisis Lasse Pedersen 15 November What is liquidity?
What is liquidity risk? A bank or investor has good funding liquidity if it has enough available funding from its own capital or from collateralised loans. With these notions in mind, the meaning of liquidity risk is clear. Market liquidity risk is the risk that the market liquidity worsens when you need to trade. Funding liquidity risk is the risk that a trader cannot fund his position and is forced to unwind.
We are experiencing extreme market and funding liquidity risk Liquidity generally varies over time and across markets, and currently we are experiencing extreme market liquidity risk. Liquidity risk and asset prices An illiquid security has a higher required return to compensate investors for the transaction costs. Liquidity risk and the current crisis: To do this, they: Garleanu and Pedersen and Brunnermeier and Pedersen The crisis spreads to other asset classes The crisis has been spreading across asset classes and markets globally.
The crisis spreads to Main Street Clearly, the crisis is having a significant effect on the real economy as homeowners see their property value deteriorate, consumers access to borrowing is reduced, main street companies face higher cost of equity and especially debt capital and a lower demand for their products, unemployment goes up, etc. What can - and what cannot - solve a liquidity crisis?
Banning short selling is a bad idea In the debate about how to solve the crisis and prevent the next one, it has been suggested that policymakers should ban short selling and impose a transaction tax on stocks.
Tobin taxes are a bad idea Second, a transaction tax on stocks is problematic for several reasons, most importantly because it moves trading away from the official exchanges and into the derivatives world, thus increasing the systemic risk. Conclusion Market liquidity risk is an important driver of security prices, risk management, and the speed of arbitrage.
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