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 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

4 Starting point: 1998 market turbulences Effective bid/ask spreads 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 successful in 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 liquidity Macroeconomic liquidity close substitutes Complements (on an aggregate basis)

8 Linking the different concepts of liquidity Market liquidity Balance sheet liquidity Funding liquidity Macroeconomic liquidity Northern Rock

9 Linking the different concepts of liquidity Market liquidity Balance sheet liquidity Funding liquidity Macroeconomic liquidity precondition for provision of market liquidity Non-linearities due to leverage

10 Linking the different concepts of liquidity Market liquidity Balance sheet liquidity Funding liquidity Macroeconomic liquidity Liquidity supplied by CB held by banks Low interest rates reduce opportunity cost of holding cash

11 Linking the different concepts of liquidity Market liquidity Balance sheet liquidity Funding liquidity Macroeconomic liquidity Loose credit standards increases funding liquidity

12 Market liquidity Balance sheet liquidity Funding liquidity Macroeconomic liquidity Market liquidity precondition for repo market Linking the different concepts of liquidity

13 Market liquidity Balance sheet liquidity Funding liquidity Macroeconomic liquidity Summer 2007: concerns about credit risk wipe out market liquidity Linking the different concepts of liquidity

14 Different concepts of liquidity closely related... … but relationship far from straightforward Liquidity can suddenly vanish (“liquidity 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 Linking the different concepts of liquidity

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 liquidity is more fragile than under others? Starting point: liquidity crises often follow periods of financial overextension (“boom-bust cycles”) Preventing liquidity crises

20 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: 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 Preventing liquidity crises

23 But success ultimately depends on management’s willingness to forego short-term gain for longer-term stability Role of monetary policy Preventing liquidity crises

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