LIQUIDITY CONCERNS What to do when such occurs ? Amandine Rogissart Thibaud Lagache

What is liquidity ? Market liquidity The ability to raise money by selling assets anytime within market hours, rapidly, with minimum loss of value and at competitive prices. Funding liquidity The ability of borrowing money without security or providing assets as security (meeting its liabilities, unwinding or settling its positions as they come due). Central Bank liquidity The ability of the central bank to supply the liquidity needed to the Financial system. Easy convertibility Fast cash flowsBuyers > Sellers

Liquidity in real motion a means whereby institutions were able to maximize claims on physical and financial assets, by insuring against losses, without increasing precautionary reserves either of capital or reserve money. CDS, ABS, MBS, Futures… a means whereby institutions were able to maximize claims on physical and financial assets, by insuring against losses, without increasing precautionary reserves either of capital or reserve money. CDS, ABS, MBS, Futures…

Scale of liquidity IlliquidLiquid Too liquid Credit Crunch Inflation Lower margins

Liquidity linkages Liquidity typeRole Funding liquidityEfficient allocation of liquidity resources. Driver of Market liquidity Market liquidity(Re)distribution and recycling of liquidity Central Bank liquidity Provision of amount of liquidity that balances demands and supply in case of systemic risks In normal periods liquidity flows easily among the three liquidity types, establishing a virtuous liquidity circle that stimulates stability in the financial system.

Liquidity linkages in turbulent times (1/4) Starting point : Funding liquidity risk The risk that a trader/investor/financial establishment cannot fund his position and is forced to unwind (default).

Liquidity linkages in turbulent times (2/4) Propagation: Market liquidity risk Propagation to the interbank market: shortage of liquidity, the banks cannot lend cash to each other. Propagation to the asset market: banks may seek liquidity through fire-sales, which will impact on asset prices (fall bellow their fundamental value) and market confidence (due to default risk).

Liquidity linkages in turbulent times (3/4)

Liquidity linkages in turbulent times (4/4) Liquidity spiral > Margin Spiral Arises from the deterioration of borrowers' balance sheet When asset prices and market liquidity drop, the funding requirements for financial institutions increase (need to back collateral value, hence : increase margin calls). Impossibiliy to raise money or renew short-term liabilities Input of new assets that the borrower must provide as security to the investor, as the initial value of the asset falls, forcing the borrower to reduce its leverage, emphasizing lower initial price. This imposes new sales, pushing margins on the rise and creating a vicious circle or spiral of margins.

Solving liquidity crisis and reducing risks Recapitalize banks Raise new capital, dilute old equity, reduce face value of old debt. Massive bail-out by governments, as liquidity remains public priority. Improve funding markets and trust Broaden bank guarantees, open discount window (collateralized funding with reasonable margins) Risk Management  Tight risk management with increasing transparency (daily updated liquidity ratios)  Acknowledge systemic risk due to liquidity spirals  More cross-border International Policy and regulation  Reduce counterparty co-dependencies  Be prepared to the worst scenario..

Focus Liquidity crisis is part of the equilibrium, If there was no risk of crisis, traders will have an incentive to lever up more. Example spiral of losses: with a margin of 10%, an investor can raise $ 100 million with a capital of 10 million, a leverage of 1 to 9. If the asset value fell to 95 million (down 5%), the net wealth of the investor it fall by half, to $ 5 million. To maintain leverage at a constant level, it must give half of the assets (50 million). He sells, causing a further decline in prices, and so on.