Liquidity crisis
Encyclopedia
In financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity (the ease with which an asset can be converted into a liquid medium e.g. cash); Funding liquidity (the ease with which borrowers can obtain external funding) Balance Sheet or Accounting liquidity
Accounting liquidity
In accounting, liquidity is a measure of the ability of a debtor to pay his debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities.-Calculating liquidity:...

(the health of an institution’s balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...

 measured in terms of its cash-like assets). Additionally, some economists define a market to be liquid if it can absorb liquidity - trades (sale of securities by investors to meet sudden needs for cash) without large changes in price. Liquidity Crisis refers to drying up of liquidity, which could reflect a fall in asset prices below their long run fundamental price; or deterioration in external financing conditions; or a reduction in the number of market participants or simply difficulty in trading assets.

The above mentioned forces mutually reinforce each other during a liquidity crisis. Market participants in need of cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...

 find it hard to locate potential trading partners to sell their assets. This may result either due to limited market participation or because of a decrease in cash held by financial market participants
Financial market participants
There are two basic financial market participant categories, Investor vs. Speculator and Institutional vs. Retail. Action in financial markets by central banks is usually regarded as intervention rather than participation.-Supply Side vs...

. Thus asset holders may be forced to sell their assets at a price below the long term fundamental price. Borrowers typically face higher loan costs and collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...

 requirements, compared to periods of ample liquidity, and unsecured debt
Unsecured debt
In finance, unsecured debt refers to any type of debt or general obligation that is not collateralised by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment....

 is nearly impossible to obtain. Typically, during a liquidity crisis, the interbank lending market
Interbank lending market
The interbank lending market is a market in which banks extend loans to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate...

 does not function smoothly either.

Several mechanisms operating through the mutual reinforcement of Asset Market Liquidity and Funding liquidity can amplify the effects of a small negative shock to the economy and result in lack of liquidity and eventually a full blown financial crisis
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...

.

A model of liquidity crisis

One of the earliest and most influential models of liquidity crisis and bank runs was given by Diamond and Dybvig in 1983. The Diamond–Dybvig model demonstrates how financial intermediation by banks, performed by accepting assets that are inherently illiquid and offering liabilities which are much more liquid (offer a smoother pattern of returns), can make banks vulnerable to a bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...

. Emphasizing the role played by demand deposit contracts in providing liquidity and better risk sharing among people, they argue that such a demand deposit
Demand deposit
Demand deposits, bank money or scriptural money are funds held in demand deposit accounts in commercial banks. These account balances are usually considered money and form the greater part of the money supply of a country.-History:...

 contract has a potential undesirable equilibrium where all depositors panic and withdraw their deposits immediately. This gives rise to self-fulfilling panics among depositors, as we observe withdrawals by even those depositors who would have actually preferred to leave their deposits in, if they were not concerned about the bank failing. This can lead to failure of even ‘healthy’ banks and eventually an economy-wide contraction of liquidity, resulting in a full blown financial crisis.

Diamond and Dybvig demonstrate that when banks provide pure demand deposit contracts, we can actually have multiple equilibrium. If confidence is maintained, such contracts can actually improve on the competitive market outcome and provide better risk sharing. In such an equilibrium, a depositor will only withdraw when it is appropriate for him to do so under optimal risk – sharing. However if agents panic, their incentives are distorted and in such an equilibrium, all depositors withdraw their deposits. Since liquidated assets are sold at a loss, therefore in this scenario, a bank will liquidate all its assets, even if not all depositors withdraw.

Note that the underlying reason for withdrawals by depositors in the Diamond–Dybvig model is a shift in expectations. Alternatively, a bank run may occur because bank’s assets, which are liquid but risky, no longer cover the nominally fixed liability (demand deposits), and depositors therefore withdraw quickly to minimize their potential losses.

The model also provides a suitable framework for analysis of devices that can be used to contain and even prevent a liquidity crisis (elaborated below).

Amplification Mechanisms

One of the mechanisms, that can work to amplify the effects of a small negative shock to the economy, is the Balance Sheet Mechanism. Under this mechanism, a negative shock in the financial market lowers asset prices and erodes the financial institution’s capital thus worsening its balance sheet. Consequently, two liquidity spirals come into effect, which amplify the impact of the initial negative shock. In an attempt to maintain its leverage ratio, the financial institution must sell its assets, precisely at a time when their price is low. Thus, assuming that asset prices depend on the health of investors’ balance sheet, erosion of investors’ net worth
Net worth
In business, net worth is the total assets minus total outside liabilities of an individual or a company. For a company, this is called shareholders' preference and may be referred to as book value. Net worth is stated as at a particular year in time...

 further reduces asset prices, which feeds back into their balance sheet and so on. This is what Brunnermeier and Pedersen (2008) term as the "loss spiral". At the same time, lending standards and margins tighten, leading to the "margin spiral". Both these effects cause the borrowers to engage in a fire sale
Fire sale
A fire sale is the sale of goods at extremely discounted prices, typically when the seller faces bankruptcy or other impending distress. The term may originally have been based on the sale of goods at a heavy discount due to fire damage...

, lowering prices and deteriorating external financing conditions.

Apart from the "Balance Sheet Mechanism" described above, the lending channel can also dry up for reasons exogenous to the borrower’s credit worthiness. For instance, banks may become concerned about their future access to capital markets in the event of a negative shock and may engage in precautionary hoarding of funds. This would result in reduction of funds available in the economy and a slowdown in economic activity. Additionally, the fact that most financial institutions are simultaneously engaged in lending and borrowing can give rise to a Network effect
Network effect
In economics and business, a network effect is the effect that one user of a good or service has on the value of that product to other people. When network effect is present, the value of a product or service is dependent on the number of others using it.The classic example is the telephone...

. In a setting that involves multiple parties, a gridlock can occur when concerns about counterparty credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

 result in failure to cancel out offsetting positions. Each party then has to hold additional funds to protect itself against the risks that are not netted out, reducing liquidity in the market. These mechanisms may explain the ‘gridlock’ observed in the interbank lending market
Interbank lending market
The interbank lending market is a market in which banks extend loans to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate...

 during the recent subprime crisis, when banks were unwilling to lend to each other and instead hoarded their reserves.

Besides, a liquidity crisis may even result due to uncertainty associated with market activities. Typically, market participants jump on the financial innovation
Financial innovation
There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...

 bandwagon, often before they can fully apprehend the risks associated with new financial assets. Unexpected behaviour of such new financial assets can lead to market participants disengaging from risks they don’t understand and investing in more liquid or familiar assets. This can be described as the Information Amplification Mechanism. In the subprime mortagage crisis, rapid endorsement and later abandonment of complicated structured finance
Structured finance
Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid lawsStructured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid laws...

 products such as Collateralized debt obligations, Mortgage-backed securities etc. played a pivotal role in amplifying the effects of a drop in property prices.

Liquidity Crunch And Flight To Liquidity

A phenomenon frequently observed during liquidity crises is Flight to liquidity as investors exit illiquid investments and turn to secondary markets in pursuit of cash–like or easily saleable assets. Empirical evidence points towards widening price differentials, during periods of liquidity shortage, among assets that are otherwise alike, but differ in terms of their asset market liquidity. For instance, there are often large liquidity premia (in some cases as much as 10-15%) in Treasury bond prices. An example of a flight to liquidity occurred during the 1998 Russian financial crisis, when the price of Treasury bonds sharply rose relative to less liquid debt instruments. This resulted in widening of credit spreads and major losses at Long Term Capital Management and many other hedge funds.

Role For Policy

There exists scope for government policy to alleviate a liquidity crunch, by absorbing less liquid assets and in turn providing the private sector with more liquid government – backed assets, through the following channels :

Pre-Emptive or Ex-Ante Policy Imposition of minimum equity
Equity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...

:capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....

 requirements or ceilings on debt-to-equity ratio on financial institutions other than commercial banks would lead to more resilient balance sheets. In the context of the Diamond–Dybvig model, an example of a demand deposit contract that mitigates banks’ vulnerability to bank runs, while allowing them to be providers of liquidity and optimal risk sharing, is one that entails suspension of convertibility
Convertibility
Convertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Convertibility is an important factor in international trade, where instruments valued in different currencies must be exchanged....

 
when there are too many withdrawals. For instance, consider a contract which is identical to the pure demand deposit contract, except that it states that a depositor will not receive anything on a given date if he attempts to prematurely withdraw, after a certain fraction of the bank’s total deposits have been withdrawn. Such a contract has a unique Nash Equilibrium
Nash equilibrium
In game theory, Nash equilibrium is a solution concept of a game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his own strategy unilaterally...

 which is stable and achieves optimal risk sharing.

Expost Policy Intervention Some experts suggest that the Central Bank should provide downside insurance in the event of a liquidity crisis. This could take the form of direct provision of insurance to asset-holders against losses or a commitment to purchasing assets in the event that the asset price falls below a threshold. Such ‘Asset Purchases’ will help drive up the demand and consequently the price of the asset in question, thereby easing the liquidity shortage faced by borrowers. Alternatively, the Government could provide ‘deposit insurance’, where it guarantees that a promised return will be paid to all those who withdraw. In the framework of the Diamond Dybvig model, demand deposit contracts with government deposit insurance help achieve the optimal equilibrium if the Government imposes an optimal tax to finance the deposit insurance. Alternative mechanisms through which the Central Bank could intervene are direct injection of equity into the system in the event of a liquidity crunch or engaging in a debt for equity swap. It could also lend through the discount window
Discount window
The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions...

, providing credit to distressed financial institutions on easier terms. However, it is argued by many economists that if the Central Bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

 declares itself as a ‘Lender of Last Resort’ (LLR), this might result in a moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

 problem, with the private sector becoming lapse and this may even exacerbate the problem. Many economists therefore assert that the LLR must only be employed in extreme cases and must be a discretion of the Government rather than a rule.

Liquidity Crisis In Emerging Markets

It has been argued by some economists that financial liberalization and increased inflows of foreign capital, especially if short term, can aggravate illiquidity of banks and increase their vulnerability. In this context, ‘International Illiquidity’ refers to a situation in which a country’s short term financial obligations denominated in foreign/hard currency exceed the amount of foreign/hard currency that it can obtain on a short notice. Empirical evidence reveals that weak fundamentals alone cannot account for all foreign capital outflows, especially from Emerging Markets
Emerging markets
Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. Based on data from 2006, there are around 28 emerging markets in the world . The economies of China and India are considered to be the largest...

. Open economy
Open economy
An open economy is an economy in which there are economic activities between domestic community and outside, e.g. people, including businesses, can trade in goods and services with other people and businesses in the international community, and flow of funds as investment across the border...

 extensions of the Diamond – Dybvig Model, where runs on domestic deposits interact with foreign creditor
Creditor
A creditor is a party that has a claim to the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption that the second party will return an equivalent property or...

 panics (depending on the maturity of the foreign debt and the possibility of international default), offer a plausible explanation for the financial crises that were observed in in Mexico, East Asia, Russia etc. These models assert that international factors can play a particularly important role in increasing domestic financial vulnerability and likelihood of a liquidity crisis.

The onset of capital outflows can have particularly destabilising consequences for emerging markets. Unlike the banks of advanced economies, which typically have a number of potential investors in the world capital markets, informational frictions imply that investors in emerging markets are ‘fair weather friends’. Thus self – fulfilling panics akin to those observed during a bank run, are much more likely for these economies. Moreover, policy distortions in these countries work to magnify the effects of adverse shocks. Given the limited access of emerging markets to world capital markets, illiquidity resulting from contemporaneous loss of domestic and foreign investor confidence is nearly sufficient to cause a financial and currency crises, the 1997 Asian financial crisis  being one example.

See also

  • Subprime mortgage crisis
    Subprime mortgage crisis
    The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

  • Insolvency
    Insolvency
    Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...

  • Liquidity crisis of September 2008
  • Financial accelerator
    Financial accelerator
    The financial accelerator in macroeconomics refers to the idea that adverse shocks to the economy may be amplified by worsening financial market conditions...

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