The Role of Liquidity in Financial Crises

TLDR: In this article, the authors use insights from the academic literature on crises to understand the role of liquidity in the current crisis and focus on four crucial features of the crisis that they argue are related to liquidity provision.

Abstract: The purpose of this paper is to use insights from the academic literature on crises to understand the role of liquidity in the current crisis. We focus on four of the crucial features of the crisis that we argue are related to liquidity provision. The first is the fall of the prices of AAA-rated tranches of securitized products below fundamental values. The second is the effect of the crisis on the interbank markets for term funding and on collateralized money markets. The third is fear of contagion should a major institution fail. Finally, we consider the effects on the real economy.

Figures

Figure 3

Figure 2 Three-month Interbank Rates Relative to Expected Policy Rates

Figure 1 Co-movement between AAA-rated US Structured Financial Instruments (in percent)

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University of Pennsylvania University of Pennsylvania
ScholarlyCommons ScholarlyCommons
Finance Papers Wharton Faculty Research
2008
The Role of Liquidity in Financial Crises The Role of Liquidity in Financial Crises
Franklin Allen
Elena Carletti
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Part of the Finance and Financial Management Commons
Recommended Citation Recommended Citation
Allen, F., & Carletti, E. (2008). The Role of Liquidity in Financial Crises.
Jackson Hole Economic Policy
Symposium,
Retrieved from https://repository.upenn.edu/fnce_papers/48
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The Role of Liquidity in Financial Crises The Role of Liquidity in Financial Crises
Abstract Abstract
The purpose of this paper is to use insights from the academic literature on crises to understand the role
of liquidity in the current crisis. We focus on four of the crucial features of the crisis that we argue are
related to liquidity provision. The 9rst is the fall of the prices of AAA-rated tranches of securitized
products below fundamental values. The second is the effect of the crisis on the interbank markets for
term funding and on collateralized money markets. The third is fear of contagion should a major
institution fail. Finally, we consider the effects on the real economy.
Disciplines Disciplines
Finance and Financial Management
This journal article is available at ScholarlyCommons: https://repository.upenn.edu/fnce_papers/48

Electronic copy available at: http://ssrn.com/abstract=1268367Electronic copy available at: http://ssrn.com/abstract=1268367
The Role of Liquidity in Financial Crises
*
Franklin Allen
**
University of Pennsylvania
and
Elena Carletti
***
University of Frankfurt
and
European University Institute
Second draft:
September 14, 2008
Abstract
The purpose of this paper is to use insights from the academic literature on crises to
understand the role of liquidity in the current crisis. We focus on four of the crucial features
of the crisis that we argue are related to liquidity provision. The first is the fall of the prices
of AAA-rated tranches of securitized products below fundamental values. The second is the
effect of the crisis on the interbank markets for term funding and on collateralized money
markets. The third is fear of contagion should a major institution fail. Finally, we consider
the effects on the real economy.
*
Prepared for the 2008 Jackson Hole Symposium, August 21-23, 2008 on Maintaining Stability in a Changing
Financial System. We are grateful to Alessio De Vincenzo of the Bank of Italy for numerous helpful discussions
and to our discussant Peter Fisher. Radomir Todorov and Zhenrui Tang provided excellent research assistance.
**
Email: allenf@wharton.upenn.edu.
***
Email: carletti@ifk-cfs.de; and, from October 1, 2008, elena.carletti@eui.eu.

Electronic copy available at: http://ssrn.com/abstract=1268367Electronic copy available at: http://ssrn.com/abstract=1268367
1
I. Introduction
The crisis that started in the summer of 2007 came as a surprise to many people.
However, for others it was not a surprise. John Paulson, the hedge fund manager, correctly
predicted the subprime debacle and earned $3.7 billion in 2007 as a result.
1
The
vulnerabilities that the global financial system has displayed were hinted at beforehand in the
Bank of England and other Financial Stability Reports.
2
The Economist magazine had been
predicting for some time that property prices in the US and a number of other countries were a
bubble and were set to fall.
3
Although the fall in US property prices that is the fundamental cause of the crisis was
widely predicted, the effects that this had on financial institutions and markets were not. In
particular, what has perhaps been most surprising is the role that liquidity has played in the
current crisis. The purpose of this paper is to use insights from the academic literature on
liquidity and crises to try to understand the role of liquidity during the last year. We focus on
four possible effects of liquidity: on pricing, on interbank and collateralized markets, on fear
of contagion, and on the real economy.
One of the most puzzling features of the crisis has been the pricing of AAA tranches
of a wide range of securitized products. It appears that the market prices of many of these
instruments are significantly below what plausible fundamentals would suggest they should
be. This pricing risk has come as a great surprise to many. We argue that the sharp change in
pricing regimes that started in August 2007 is consistent with what is known in the academic
literature as “cash-in-the-market” pricing. Holding liquidity is costly because less liquid
assets usually have higher returns. In order for providers of liquidity to markets to be
compensated for this opportunity cost, they must on occasion be able to make a profit by
buying up assets at prices below fundamentals. Once the link between prices and
1
Financial Times, January 15, 2008 and June 18, 2008.
2
See, for example, Bank of England (2006) and (2007).
3
See, for example, Economist (2005) and (2006).

2
fundamentals is broken then arbitrage becomes risky and the usual forces that drive prices and
fundamentals together no longer work. This limit to arbitrage means that prices can deviate
from fundamentals for protracted periods.
The second surprise has been the way in which the money markets have operated. The
interbank markets for terms longer than a few days have experienced considerable pressures.
In addition, the way that the collateralized markets operate has changed significantly.
Haircuts have increased and low quality collateral has become more difficult to borrow
against. The Federal Reserve and other central banks have introduced a wide range of
measures to try to improve the smooth functioning of the money markets. The extent to
which these events affect the functioning of the financial system and justifies central bank
intervention depends on the possible explanations as to why the markets stopped operating
smoothly. One of the main roles of interbank markets is to reallocate liquidity among banks
that are subject to idiosyncratic shocks. If banks hoard liquidity and as a result they are able
to cover idiosyncratic shocks from their own liquidity holdings, then their unwillingness to
lend to other banks is not a problem. If, on the contrary, the liquidity hoarding prevents the
reshuffling of liquidity to deficient, but solvent banks, then the badly functioning interbank
market is a problem warranting central bank liquidity provision. Allowing banks to exchange
mortgage backed securities for Treasuries is desirable if it improves collateralized lending in
the repo market but is not if it simply leads to more window dressing by financial institutions.
In this case the actions of the Federal Reserve are simply removing market discipline.
The third aspect of the crisis that we consider relates to contagion risk. The
controversial use of public funds in the arranged merger of Bear Stearns with J. P. Morgan
was justified by the possibility of contagion. If Bear Stearns had been allowed to fail, its
extensive involvement as counterparty in many derivatives markets may have caused a string
of defaults. There is a large literature on the likelihood of contagion between banks based on
simulations. The conclusion of this literature is that contagion in banking is unlikely.

Frequently asked questions

Q1. What have the authors contributed in "The role of liquidity in financial crises" ?

The purpose of this paper is to use insights from the academic literature on crises to understand the role of liquidity in the current crisis. Finally, the authors consider the effects on the real economy. This journal article is available at ScholarlyCommons: https: //repository. 

Q2. What are the future works mentioned in the paper "The role of liquidity in financial crises" ?

However, in crisis times they are not because the possibility of default will cause a flight to quality. Theoretical analysis suggests that the process of contagion where default cascades through the financial system represents a significant danger. In Allen and Carletti ( 2008b ) the authors suggest that in financial crisis situations where liquidity is scarce and prices are low as a result, market prices should be supplemented with both model-based and historic cost valuations. In such cases the potential damage caused by the prospect of contagion if one of them were to fail is very large. 

Q3. What are the reasons for the large discounts in prices for risky securities?

Strong adverse selection and moral hazard problems provide a potential explanation for the large discounts in prices for risky securities like those backed by subprime mortgages. 

Q4. What is the main reason for the drying up of interbank markets?

The drying up of liquidity in interbank markets is usually attributed to a mixture ofliquidity hoarding by banks to counter the increased uncertainty over aggregate liquidity demand and fear of lending to other banks. 

Q5. What is the effect of mark-to-market accounting?

when markets do not work perfectly and prices do not always reflect the value of fundamentals as in the case where there is cash-in-the-market pricing, mark-to-market accounting exposes the value of the balance sheets of financial institutions to short-term and excessive fluctuations, and it can ultimately generate contagion. 

Q6. What is the reason that the prices of other securities fell?

The reason that the prices of other securities such as AAA-rated tranches of commercial mortgage backed securities also fell is that they are traded by the same desks as securitized subprime products and so sales of these also led to a drop in prices. 

Q7. What is the basic problem an intermediary faces if it is hit by a liquidity shock?

The basic problem an intermediary faces if it is hit by a liquidity shock is whether tosell its assets now at a discount or to try and ride out the crisis. 

Q8. How can central banks remove the inefficiency deriving from the asset price volatility?

13equivalently fix the short term interest rate), central banks can remove the inefficiency deriving from the asset price volatility and achieve the same allocation as with complete markets (Allen, Carletti and Gale, 2008). 

Q9. What is the main reason for the significant discounts on securitized tranches?

The authors suggest that the significant discounts on AAA-rated tranches of securitizedproducts that are too large to be explained by the underlying fundamentals are the result of cash-in-the-market pricing. 

Q10. What is the way to estimate the impact of contagion on the Belgian interbank?

Simulations of the worst case scenarios show that banks representing less than 5% of total balance sheet assets would be affected by contagion on the Belgian interbank market, while for the German system the failure of a single bank could lead to the breakdown of up to 15% of the banking sector in terms of assets. 

Q11. What is the reason for the decline in prices of subprime mortgages?

According to the Bank of England (2008, pp. 18-21) if this change in price was due to deterioration in fundamentals, then it would be necessary to believe that the ultimate percentage loss rate of securitized subprime mortgages would be 38 percent. 

Q12. What is the effect of a failed institution on asset prices?

The effect on asset prices may be large if failed institutions are forced to liquidate assets and there is cash-in-the market pricing. 

Q13. What is the reason for the price anomalies in the AAA-rated tranches of securities?

Another possible explanation of the pricing anomalies in the AAA-rated tranches ofsecuritized securities is that they are due to asymmetric information as, for example, in Bolton, Santos and Scheinkman (2008). 

Q14. What is the benefit of mark-to-market accounting?

This accounting method has the benefit of reflecting the market value of the balance sheets of financial institutions and therefore of allowing regulators, investors and other users of accounting information to better assess the risk profile of financial institutions. 

Q15. Why do these papers show how the buffers of capital of the surviving intermediaries are more?

The reason is that the buffers of capital of the surviving intermediaries are more likely to be large enough to absorb the default, especially if each of them has only small claims with the troubled intermediary. 

Q16. What is the main reason why the prices of subprime securities have fallen?

With segmented markets the theory can also explain why different but related types of security would also be affected so their prices would tend to fall as well.