Market liquidity and funding liquidity

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Market liquidity and funding liquidity

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Market liquidity and funding liquidity

Markus K. Brunnermeier¹, Lasse Heje Pedersen²•Institutions (2)

Princeton University¹, New York University²

01 Feb 2007-Research Papers in Economics (Financial Markets Group)-

TL;DR: In this article, the authors provide a model that links an asset's market liquidity and traders' funding liquidity, i.e., the ease with which they can obtain funding, to explain the empirically documented features that market liquidity can suddenly dry up, has commonality across securities, is related to volatility, is subject to flight to quality, and comoves with the market.

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Abstract: We provide a model that links an asset's market liquidity - i.e., the ease with which it is traded - and traders' funding liquidity - i.e., the ease with which they can obtain funding. Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and the margins they are charged, depend on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to “flight to quality¶, and (v) comoves with the market, and it provides new testable predictions. Keywords: Liquidity Risk Management, Liquidity, Liquidation, Systemic Risk, Leverage, Margins, Haircuts, Value-at-Risk, Counterparty Credit Risk

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Posted Content•

Intermediary Asset Pricing

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Zhiguo He¹, Arvind Krishnamurthy²•Institutions (2)

University of Chicago¹, Northwestern University²

27 Feb 2012-Social Science Research Network

TL;DR: In this paper, the authors model the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary and evaluate the effect of three government policies: reducing intermediaries borrowing costs, injecting equity capital, and purchasing distressed assets.

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Abstract: We model the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary. Intermediaries face an equity capital constraint. Risk premia rise when the constraint binds, reflecting the capital scarcity. The calibrated model matches the nonlinearity of risk premia during crises, and the speed of reversion in risk premia from a crisis back to pre-crisis levels. We evaluate the effect of three government policies: reducing intermediaries borrowing costs, injecting equity capital, and purchasing distressed assets. Injecting equity capital is particularly effective because it alleviates the equity capital constraint that drives the model's crisis.

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864 citations

Cites background from "Market liquidity and funding liquid..."

...Using (21) and (14), we can express dRt and dct ct in terms of the price/dividend ratio p(x) and its derivatives....
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Journal Article•DOI•

The crisis of fair-value accounting: Making sense of the recent debate

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Christian Laux¹, Christian Leuz²•Institutions (2)

Goethe University Frankfurt¹, University of Chicago²

01 Aug 2009-Accounting Organizations and Society

TL;DR: The recent financial crisis has led to a vigorous debate about the pros and cons of fair value accounting (FVA) as discussed by the authors, and this debate presents a major challenge for FVA going forward and standard setters' push to extend FVA into other areas.

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Abstract: The recent financial crisis has led to a vigorous debate about the pros and cons of fair-value accounting (FVA). This debate presents a major challenge for FVA going forward and standard setters’ push to extend FVA into other areas. In this article, we highlight four important issues as an attempt to make sense of the debate. First, much of the controversy results from confusion about what is new and different about FVA. Second, while there are legitimate concerns about marking to market (or pure FVA) in times of financial crisis, it is less clear that these problems apply to FVA as stipulated by the accounting standards, be it IFRS or US GAAP. Third, historical cost accounting (HCA) is unlikely to be the remedy. There are a number of concerns about HCA as well and these problems could be larger than those with FVA. Fourth, although it is difficult to fault the FVA standards per se, implementation issues are a potential concern, especially with respect to litigation. Finally, we identify several avenues for future research.

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810 citations

Journal Article•DOI•

Complexity, concentration and contagion

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Prasanna Gai¹, Andrew Haldane², Sujit Kapadia²•Institutions (2)

University of Auckland¹, Bank of England²

01 Jul 2011-Journal of Monetary Economics

TL;DR: In this paper, the authors develop a network model of interbank lending in which unsecured claims, repo activity and shocks to the haircuts applied to collateral assume centre stage, and show how systemic liquidity crises of the kind associated with the interbank market collapse of 2007-2008 can arise within such a framework, with funding contagion spreading widely through the web of interlinkages.

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778 citations

Cites background from "Market liquidity and funding liquid..."

...Although they do not consider how such behaviour may propagate through the interbank network, their story of a precautionary motive for liquidity hoarding is consistent with the view of hoarding taken in this paper; indeed, it may be interpreted as providing a behavioural foundation for it....
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...It shows the marked rise 6On the ampli cation role of haircut shocks, see Brunnermeier and Pedersen (2009), Adrian and Shin (2010a), Geanakoplos (2010) and Gorton and Metrick (2010)....
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Journal Article•DOI•

Monetary Policy as Financial Stability Regulation

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Jeremy C. Stein¹•Institutions (1)

National Bureau of Economic Research¹

01 Feb 2012-Quarterly Journal of Economics

TL;DR: In this article, the authors develop a model that speaks to the goals and methods of financial stability policies, and show how in a simple economy where commercial banks are the only lenders, conventional monetary-policy tools such as open-market operations can be used to regulate this externality, while in more advanced economies it may be helpful to supplement monetary policy with other measures.

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Abstract: This paper develops a model that speaks to the goals and methods of financialstability policies. There are three main points. First, from a normative perspective, the model defines the fundamental market failure to be addressed, namely that unregulated private money creation can lead to an externality in which intermediaries issue too much short-term debt and leave the system excessively vulnerable to costly financial crises. Second, it shows how in a simple economy where commercial banks are the only lenders, conventional monetary-policy tools such as open-market operations can be used to regulate this externality, while in more advanced economies it may be helpful to supplement monetary policy with other measures. Third, from a positive perspective, the model provides an account of how monetary policy can influence bank lending and real activity, even in a world where prices adjust frictionlessly and there are other transactions media besides bank-created money that are outside the control of the central bank.

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755 citations

Cites background from "Market liquidity and funding liquid..."

...It also shows that a cap-and-trade approach to regulation can 6 On fire sales, see also Allen and Gale (2005), Brunnermeier and Pedersen (2009), Fostel and Geanakoplos (2008), Geanakoplos (2009), Gromb and Vayanos (2002), Morris and Shin (2004), Caballero and Simsek (2009), and Stein (2009)....
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Journal Article•DOI•

Macroprudential policy – a literature review

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Gabriele Galati¹, Richhild Moessner²•Institutions (2)

De Nederlandsche Bank¹, Bank for International Settlements²

11 May 2012-Journal of Economic Surveys

TL;DR: The recent financial crisis has highlighted the need to go beyond a purely micro approach to financial regulation and supervision and the number of policy speeches, research papers and conferences that discuss a macro perspective on financial regulation has grown considerably.

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Abstract: The recent financial crisis has highlighted the need to go beyond a purely micro approach to financial regulation and supervision. As a consequence, the number of policy speeches, research papers and conferences that discuss a macro perspective on financial regulation has grown considerably. The policy debate is focusing in particular on macroprudential tools and their usage, their relationship with monetary policy, their implementation and their effectiveness. Macroprudential policy has recently also attracted considerable attention among researchers. This paper provides an overview of research on this topic. We also identify important future research questions that emerge from both the literature and the current policy debate.

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732 citations

Cites background from "Market liquidity and funding liquid..."

...See BIS (2001); Borio et al. (2001); Danielsson et al. (2001); Borio and Zhu (2008); Brunnermeier et al. (2009); Brunnermeier and Pedersen (2009) and Shin (2009)....
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References

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Posted Content•DOI•

Credit Rationing in Markets with Imperfect Information.

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Joseph E. Stiglitz, Andrew Weiss

01 Jan 1981-The American Economic Review

TL;DR: In this paper, a model is developed to provide the first theoretical justification for true credit rationing in a loan market, where the amount of the loan and amount of collateral demanded affect the behavior and distribution of borrowers, and interest rates serve as screening devices for evaluating risk.

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Abstract: According to basic economics, if demand exceeds supply, prices will rise, thus decreasing demand or increasing supply until demand and supply are in equilibrium; thus if prices do their job, rationing will not exist. However, credit rationing does exist. This paper demonstrates that even in equilibrium, credit rationing will exist in a loan market. Credit rationing is defined as occurring either (a) among loan applicants who appear identical, and some do and do not receive loans, even though the rejected applicants would pay higher interest rates; or (b) there are groups who, with a given credit supply, cannot obtain loans at any rate, even though with larger credit supply they would. A model is developed to provide the first theoretical justification for true credit rationing. The amount of the loan and the amount of collateral demanded affect the behavior and distribution of borrowers. Consequently, faced with increased credit demand, it may not be profitable to raise interest rates or collateral; instead banks deny loans to borrowers who are observationally indistinguishable from those receiving loans. It is not argued that credit rationing always occurs, but that it occurs under plausible assumptions about lender and borrower behavior. In the model, interest rates serve as screening devices for evaluating risk. Interest rates change the behavior (serve as incentive mechanism) for the borrower, increasing the relative attractiveness of riskier projects; banks ration credit, rather than increase rates when there is excess demand. Banks are shown not to increase collateral as a means of allocating credit; although collateral may have incentivizing effects, it may have adverse selection effects. Equity, nonlinear payment schedules, and contingency contracts may be introduced and yet there still may be rationing. The law of supply and demand is thus a result generated by specific assumptions and is model specific; credit rationing does exist. (TNM)

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13,126 citations

"Market liquidity and funding liquid..." refers background in this paper

...…private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and Grossman and Miller (1988)), search frictions (Duffie, Gârleanu, and Pedersen (2003, 2003a)), or predatory trading…...
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...…order processing costs, private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and Grossman and Miller (1988)), search frictions (Duffie, Gârleanu, and Pedersen (2003, 2003a)), or…...
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Journal Article•DOI•

Continuous Auctions and Insider Trading

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Albert S. Kyle

01 Nov 1985-Econometrica

9,341 citations

"Market liquidity and funding liquid..." refers background in this paper

...A bank’s capital W consists of equity capital plus its long-term borrowings (including credit lines secured from individual or syndicates of commercial banks), reduced by assets that cannot be readily employed (e.g. goodwill, intangible assets, property, equipment, and capital needed for daily…...
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...…a security can be costly to trade — that is, has less than perfect market liquidity — because of exogenous order processing costs, private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and…...
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Journal Article•DOI•

Bank Runs, Deposit Insurance, and Liquidity

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Douglas W. Diamond, Philip H. Dybvig

01 Jun 1983-Journal of Political Economy

TL;DR: The authors showed that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits, and showed that there are circumstances when government provision of deposit insurance can produce superior contracts.

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Abstract: This paper shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts.

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9,099 citations

"Market liquidity and funding liquid..." refers background or result in this paper

...Most of the banking literature follows Diamond and Dybvig (1983) in assuming an exogenous liquidation technology — that is, market liquidity is not endogenized....
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...However, as Bryant (1980) and Diamond and Dybvig (1983) show, banks are subject to bank-runs if they offer demand deposit contracts (and markets are incomplete)....
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...Gromb and Vayanos (2002) derive welfare results in a model in which arbitrageurs face margin constraints similar to those in our model....
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Book•

The econometrics of financial markets

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John Y. Campbell¹, Andrew W. Lo¹, A. Craig MacKinlay¹•Institutions (1)

Princeton University¹

01 Jan 1997

TL;DR: In this paper, Campbell, Lo, and MacKinlay present an attempt by three well-known and well-respected scholars to fill an acknowledged void in the empirical finance literature, a text covering the burgeoning field of empirical finance.

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Abstract: This book is an ambitious effort by three well-known and well-respected scholars to fill an acknowledged void in the literature—a text covering the burgeoning field of empirical finance. As the authors note in the preface, there are several excellent books covering financial theory at a level suitable for a Ph.D. class or as a reference for academics and practitioners, but there is little or nothing similar that covers econometric methods and applications. Perhaps the closest existing text is the recent addition to the Wiley Series in Financial and Quantitative Analysis. written by Cuthbertson (1996). The major difference between the books is that Cuthbertson focuses exclusively on asset pricing in the stock, bond, and foreign exchange markets, whereas Campbell, Lo, and MacKinlay (henceforth CLM) consider empirical applications throughout the field of finance, including corporate finance, derivatives markets, and market microstructure. The level of anticipation preceding publication can be partly measured by the fact that at least three reviews (including this one) have appeared since the book arrived. Moreover, in their reviews, both Harvey (1998) and Tiso (1998) comment on the need for such a text, a sentiment that has been echoed by numerous finance academics.

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7,169 citations

"Market liquidity and funding liquid..." refers background in this paper

...Empirically, fundamental volatility can be captured using price changes over a longer time period, and the total fundamental and liquidity-based volatility is captured by short-term price changes as in the literature on variance ratios (see e.g. Campbell, Lo, and MacKinlay (1997) )....
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Journal Article•DOI•

Bid, ask and transaction prices in a specialist market with heterogeneously informed traders

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Lawrence R. Glosten¹, Lawrence R. Glosten², Paul Milgrom³•Institutions (3)

Northwestern University¹, University of Chicago², Yale University³

01 Mar 1985-Journal of Financial Economics

TL;DR: The presence of traders with superior information leads to a positive bid-ask spread even when the specialist is risk-neutral and makes zero expected profits as discussed by the authors, and the expectation of the average spread squared times volume is bounded by a number that is independent of insider activity.

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5,902 citations

"Market liquidity and funding liquid..." refers background in this paper

...…be costly to trade — that is, has less than perfect market liquidity — because of exogenous order processing costs, private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and Grossman and…...
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...Holmström and Tirole’s (1998, 2001) research focuses primarily on funding liquidity. They show that corporations with agency problems have a preference for government bonds because they provide a cushion for future funding liquidity problems. Hence, government bonds trade at a premium. Our paper is also related to parts of the literature on the “limits to arbitrage.”(17) Shleifer and Vishny (1997) show, among other things, that a demand shock can be amplified if losses lead to withdrawal of capital from fund managers. We show that a similar effect can arise due to leverage and document how the multiplier is exacerbated by the degree of leverage (Proposition 2) and that this funding effect can lead to fragility (Proposition 1). Liu and Longstaff (2004) derive the optimal dynamic arbitrage strategy under funding constraints in a setting with an exogenous price process....
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...Holmström and Tirole’s (1998, 2001) research focuses primarily on funding liquidity. They show that corporations with agency problems have a preference for government bonds because they provide a cushion for future funding liquidity problems. Hence, government bonds trade at a premium. Our paper is also related to parts of the literature on the “limits to arbitrage.”(17) Shleifer and Vishny (1997) show, among other things, that a demand shock can be amplified if losses lead to withdrawal of capital from fund managers....
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