Showing papers on "Liquidity risk published in 2009"
TL;DR: In this article, the authors provide a model that links a security's market liquidity and traders' funding liquidity, i.e., their availability of funds, to explain the empirically documented features that market liquidity can suddenly dry up (i) is fragile), (ii) has commonality across securities, (iii) is related to volatility, and (iv) experiences “flight to liquidity” events.
Abstract: We provide a model that links a security’s market liquidity — i.e., the ease of trading it — and traders’ funding liquidity — i.e., their availability of funds. Traders provide market liquidity and their ability to do so depends on their funding, that is, their capital and the margins charged by their financiers. In times of crisis, reductions in market liquidity and funding liquidity are mutually reinforcing, leading to a liquidity spiral. The model explains the empirically documented features that market liquidity (i) can suddenly dry up (i.e. is fragile), (ii) has commonality across securities, (iii) is related to volatility, (iv) experiences “flight to liquidity” events, and (v) comoves with the market. Finally, the model shows how the Fed can improve current market liquidity by committing to improve funding in a potential future crisis.
3,166 citations
TL;DR: In a financial system in which balance sheets are continuously marked to market, asset price changes appear immediately as changes in net worth, eliciting responses from financial intermediaries who adjust the size of their balance sheets as mentioned in this paper.
Abstract: In a financial system in which balance sheets are continuously marked to market, asset price changes appear immediately as changes in net worth, eliciting responses from financial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in dealer repos—the primary margin of adjustment for the aggregate balance sheets of intermediaries—forecast changes in financial market risk as measured by the innovations in the Chicago Board Options Exchange Volatility Index (VIX). Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.
1,950 citations
TL;DR: The authors survey 1,050 CFOs in the US, Europe, and Asia to assess whether their firms are credit constrained during the global financial crisis of 2008 and find that constrained firms planned deeper cuts in tech spending, employment, and capital spending.
Abstract: We survey 1,050 CFOs in the US, Europe, and Asia to directly assess whether their firms are credit constrained during the global financial crisis of 2008 We study whether corporate spending plans differ conditional on this survey-based measure of financial constraint Our evidence indicates that constrained firms planned deeper cuts in tech spending, employment, and capital spending Constrained firms also burned through more cash, drew more heavily on lines of credit for fear banks would restrict access in the future, and sold more assets to fund their operations We also find that the inability to borrow externally caused many firms to bypass attractive investment opportunities, with 86% of constrained US CFOs saying their investment in attractive projects was restricted during the credit crisis of 2008 More than half of the respondents said they canceled or postponed their planned investments Our results also hold in Europe and Asia, and in many cases are stronger in those economies Our analysis adds to the portfolio of approaches and knowledge about the impact of credit constraints on real firm behavior
1,467 citations
TL;DR: In this article, the authors compared three measures, effective spread, realized spread, and price impact based on both Trade and Quote (TAQ) and Rule 605 data, and found that the new effective/realized spread measures win the majority of horseraces, while the Amihud [2002.5] measure does well measuring price impact.
1,287 citations
TL;DR: This paper found that bank liquidity creation increased every year and exceeded $2.8 trillion in 2003 and that the relationship between capital and liquidity creation was positive for large banks and negative for small banks.
Abstract: Although the modern theory of financial intermediation portrays liquidity creation as an essential role of banks, comprehensive measures of bank liquidity creation do not exist. We construct four measures and apply them to data on virtually all U.S. banks from 1993 to 2003. We find that bank liquidity creation increased every year and exceeded $2.8 trillion in 2003. Large banks, multibank holding company members, retail banks, and recently merged banks created the most liquidity. Bank liquidity creation is positively correlated with bank value. Testing recent theories of the relationship between capital and liquidity creation, we find that the relationship is positive for large banks and negative for small banks. (JEL G21, G28, G32)
863 citations
TL;DR: The authors empirically examined the factors that determine whether firms use bank lines of credit or cash in corporate liquidity management and found that firms with low cash flow are less likely to obtain a line of credit, and they rely more heavily on cash in their corporate Liquidity Management.
Abstract: I empirically examine the factors that determine whether firms use bank lines of credit or cash in corporate liquidity management. I find that bank lines of credit, also known as revolving credit facilities, are a viable liquidity substitute only for firms that maintain high cash flow. In contrast, firms with low cash flow are less likely to obtain a line of credit, and they rely more heavily on cash in their corporate liquidity management. An important channel for this correlation is the use of cash flow-based financial covenants by banks that supply credit lines. I find that firms must maintain high cash flow to remain compliant with covenants, and banks restrict firm access to credit facilities in response to covenant violations. Using the cash-flow sensitivity of cash as a measure of financial constraints, I provide evidence that lack of access to a line of credit is a more statistically powerful measure of financial constraints than traditional measures used in the literature. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.
574 citations
TL;DR: In a market-based financial system, banking and capital market developments are inseparable, and funding conditions are closely tied to fluctuations in the leverage of marketbased financial intermediaries as mentioned in this paper.
Abstract: In a market-based financial system, banking and capital market developments are inseparable, and funding conditions are closely tied to fluctuations in the leverage of market-based financial intermediaries. Offering a window on liquidity, the balance sheet growth of broker-dealers provides a sense of the availability of credit. Contractions of broker-dealer balance sheets have tended to precede declines in real economic growth, even before the current turmoil. For this reason, balance sheet quantities of market-based financial intermediaries are important macroeconomic state variables for the conduct of monetary policy.
492 citations
TL;DR: Manganelli and Wolswijk as mentioned in this paper found that the Eurosystem's short-term interest rates are positively related to those spreads, which include significant and policy-relevant default risk and liquidity risk components.
Abstract: Spreads between euro area government bond yields are related to short-term interest rates, which are in turn related to market liquidity, to cyclical conditions, and to investors’ incentives to take risk. In theory, lower interest rates are associated with lower degrees of risk aversion and smaller government bond spreads. Empirically, the Eurosystem’s short-term interest rates are positively related to those spreads, which our econometric model finds to include significant and policy-relevant default risk and liquidity risk components.
— Simone Manganelli and Guido Wolswijk
414 citations
TL;DR: In this paper, the authors exploit the inability of Fannie Mae and Freddie Mac to purchase jumbo mortgages to identify an exogenous change in liquidity and find that the volume of jumbo mortgage originations relative to nonjumbo originations increases with bank holdings of liquid assets and decreases with bank deposit costs.
Abstract: Low-cost deposits and increased balance sheet liquidity raise banks' supply of illiquid loans more than loans easily sold or securitized. We exploit the inability of Fannie Mae and Freddie Mac to purchase jumbo mortgages to identify an exogenous change in liquidity. The volume ofjumbo mortgage originations relative to nonjumbo origina tions increases with bank holdings of liquid assets and decreases with bank deposit costs. This result suggests that the increasing depth of the mortgage secondary mar ket fostered by securitization has reduced the effect of lender's financial condition on credit supply. LIQUIDITY TRANSFORMATION-THE FUNDING OF ILLIQUID LOANS with liquid deposits has been viewed as a fundamental role of banks. Diamond and Dybvig (1983), for example, argue that banks improve welfare by allowing depositors to diversify liquidity risk while investing in high return but illiquid projects. In recent years, however, securitization has changed the way banks provide liquidity.' While real projects remain illiquid, loans have become more liquid because banks often securitize them, replacing deposits with bonds as a source of finance. Today, more than 60% of outstanding mortgages are securitized. As loans have become more liquid, credit supply has become less sensitive to changes in bank's financial condition. For example, a bank has the option to finance a liquid loan either with deposits or, via securitization, with funds from capital markets. Liquidity provides a substitute source of finance for loan origination because the originator need not hold the loan. In contrast, illiquid loans must be held and thus funded by the originating lender. An increase in the originator's costs of deposits (e.g., from tight monetary policy) could thus restrict the supply of illiquid loans. Many financial assets have been securitized in recent years, with the growth of structured products such as collateralized debt obligations (CDOs),
398 citations
TL;DR: In this article, the authors develop a simple model of the interbank market where banks trade a long term, safe asset and a central bank can implement the constrained efficient allocation by using open market operations to fix the short term interest rate.
396 citations
TL;DR: In this paper, the authors study how trading frictions in asset markets affect the distribution of asset holdings, asset prices, efficiency, and standard measures of liquidity, and show that a reduction in trading friction leads to an increase in the dispersion of assets and trade volume.
Abstract: We study how trading frictions in asset markets affect the distribution of asset holdings, asset prices, efficiency, and standard measures of liquidity. To this end, we analyze the equilibrium and optimal allocations of a search-theoretic model of financial intermediation similar to Duffie, Gârleanu and Pedersen (2005). In contrast with the existing literature, the model we develop imposes no restrictions on asset holdings, so traders can accommodate frictions by varying their trading needs through changes in their asset positions. We find that this is a critical aspect of investor behavior in illiquid markets. A reduction in trading frictions leads to an increase in the dispersion of asset holdings and trade volume. Transaction costs and intermediaries’ incentives to make markets are nonmonotonic in trade frictions. With the entry of dealers, these nonmonotonicities give rise to an externality in liquidity provision that can lead to multiple equilibria. Tight spreads are correlated with large volume and short trading delays across equilibria. From a normative standpoint we show that the asset allocation across investors and the number of dealers are socially inefficient.
Book•
30 May 2009TL;DR: In this article, the authors describe how the crisis exposed regulatory failings, drawing largely on UK experience, and suggest remedies, and how to allocate the burden of cross-border defaults.
Abstract: There are numerous aspects concerning financial regulation which the current financial turmoil has high-lighted. These include: (1) the form of deposit insurance; (2) bank solvency regimes, ‘prompt corrective action’; (3) Central Banks’ money market operations; (4) commercial bank liquidity risk management; (5) procyclicality of CARs (and mark-to-market); lack of counter-cyclical instruments; (5) boundaries of regulation, conduits, SIVs and reputational risk; (6) crisis management: (a) within countries, e.g. UK Tripartite Committee; or (b) cross-border, how to allocate the burden of cross-border defaults? This paper describes how the crisis exposed regulatory failings, drawing largely on UK experience, and suggests remedies.
Posted Content•
TL;DR: In this paper, the authors derive an equilibrium asset pricing model incorporating liquidity risk, derivative assets, and short-selling due to hedging of non-traded risk, and find strong evidence for an expected liquidity premium earned by the credit protection seller.
Abstract: We derive an equilibrium asset pricing model incorporating liquidity risk, derivative assets, and short-selling due to hedging of non-traded risk. We show that, both for positive-net-supply assets and derivatives, the sign of liquidity effects depends on investor heterogeneity in non-traded risk exposure, risk aversion, horizon and wealth. We also show that liquidity risk affects derivatives in a different way than positive-net-supply assets. We estimate this model for the credit default swap market using GMM. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.
TL;DR: In this paper, the authors present a model of fire sales and market breakdowns, and of the financial amplification mechanism that follows from them, and the distinctive feature of their model is the central role played by endogenous uncertainty.
Abstract: In this paper we present a model of fire sales and market breakdowns, and of the financial amplification mechanism that follows from them. The distinctive feature of our model is the central role played by endogenous uncertainty. As conditions deteriorate, more “banks” within the financial network become distressed, which increases each (non-distressed) bank’s likelihood of being hit by an indirect shock. As this happens, banks face an increasingly complex environment since they need to understand more and more interlinkages in making their financial decisions. Uncertainty comes as a by-product of this complexity, and makes relatively healthy banks, and hence potential asset buyers, reluctant to buy. The liquidity of the market quickly vanishes and a financial crisis ensues. The model features a novel complexity externality which provides a rationale for various government policies commonly used during financial crises, including bailouts and asset price supports.
TL;DR: The authors showed that hedge funds that significantly load on liquidity risk subsequently outperform low-loading funds by about 6% annually, on average, over the period 1994-2008, while negative performance is observed during periods of significant liquidity crises.
Abstract: This paper demonstrates that liquidity risk as measured by the covariation of fund returns with unexpected changes in aggregate liquidity is an important determinant in the cross-section of hedge-fund returns. The results show that funds that significantly load on liquidity risk subsequently outperform low-loading funds by about 6% annually, on average, over the period 1994-2008, while negative performance is observed during periods of significant liquidity crises. The returns are independent of the liquidity a fund provides to its investors as measured by lockup and redemption notice periods, and are also robust to commonly used hedge-fund factors, none of which carries a significant premium during the sample period. These findings highlight the importance of understanding systematic liquidity variations in the evaluation of hedge-fund performance.
TL;DR: In this article, the authors propose definitions of funding liquidity and funding liquidity risk and present a simple, yet intuitive, measure of fund liquidity risk based on data from open market operations, using a unique dataset of 135 main refinancing operation auctions conducted at the ECB between June 2005 and December 2007.
Abstract: In this paper we propose definitions of funding liquidity and funding liquidity risk and present a simple, yet intuitive, measure of funding liquidity risk based on data from open market operations Our empirical analysis uses a unique data set of 135 main refinancing operation auctions conducted at the ECB between June 2005 and December 2007 We find that our proxies for funding liquidity risk are typically stable and low, with occasional spikes, especially during the recent turmoil We are also able to document downward spirals between funding liquidity risk and market liquidity
TL;DR: In this article, the authors use a unique dataset to show that relationships are an important determinant of banks' ability to access interbank market liquidity, and they find that banks with a larger reserve imbalance are more likely to borrow funds from banks with whom they have a relationship, and to pay a lower interest rate than otherwise.
TL;DR: In this article, the authors measure the systemic risk of a banking sector as a hypothetical distress insurance premium, identifies various sources of financial instability, and allocates systemic risk to individual financial institutions.
TL;DR: In this paper, the authors demonstrate how the introduction of liability-side feedbacks affects the properties of a quantitative model of systemic risk, known as RAMSI, based on detailed balance sheets for UK banks and encompasses macro-credit risk, interest and non-interest income risk, network interactions, and feedback effects.
Abstract: We demonstrate how the introduction of liability-side feedbacks affects the properties of a quantitative model of systemic risk. The model is known as RAMSI and is still in its development phase. It is based on detailed balance sheets for UK banks and encompasses macro-credit risk, interest and non-interest income risk, network interactions, and feedback effects. Funding liquidity risk is introduced by allowing for rating downgrades and incorporating a simple framework in which concerns over solvency, funding profiles and confidence may trigger the outright closure of funding markets to particular institutions. In presenting results, we focus on aggregate distributions and analysis of a scenario in which large losses at some banks can be exacerbated by liability-side feedbacks, leading to system-wide instability.
Posted Content•
TL;DR: In this paper, the authors describe two amplifications mechanisms that operate during liquidity crises and discuss the scope for central bank policies during crises as well as preventive policies in advance of crises.
Abstract: I describe two amplifications mechanisms that operate during liquidity crises and discuss the scope for central bank policies during crises as well as preventive policies in advance of crises. The first mechanism works through asset prices and balance sheets. A negative shock to the balance sheets of asset-holders causes them to liquidate assets, lowering prices, further deteriorating balance sheets, culminating in a crisis. The second mechanism involves investors' Knightian uncertainty. Unusual shocks to untested financial innovations lead agents to become uncertain about their investments causing them to disengage from markets and increase their demand for liquidity. This behavior leads to a loss of liquidity and a crisis.
TL;DR: In this article, the authors propose a simple implementation of the optimum that imposes a constraint on the portfolio share that financial intermediaries invest in short-term assets, which improves risk sharing by reducing the attractiveness of joint deviations.
Abstract: This paper studies a Diamond-Dybvig model of providing insurance against unobservable liquidity shocks in the presence of unobservable trades. We show that competitive equilibria are inefficient. A social planner finds it beneficial to introduce a wedge between the interest rate implicit in optimal allocations and the economy's marginal rate of transformation. This improves risk sharing by reducing the attractiveness of joint deviations where agents simultaneously misrepresent their type and engage in trades on private markets. We propose a simple implementation of the optimum that imposes a constraint on the portfolio share that financial intermediaries invest in short-term assets. Copyright , Wiley-Blackwell.
Posted Content•
TL;DR: In this article, the authors examine algorithmic trades and their role in the price discovery process in the 30 DAX stocks on the Deutsche Boerse and show that AT liquidity demand represents 52% of the volume and AT supplies liquidity on 50% of volume.
Abstract: We examine algorithmic trades (AT) and their role in the price discovery process in the 30 DAX stocks on the Deutsche Boerse. AT liquidity demand represents 52% of volume and AT supplies liquidity on 50% of volume. AT act strategically by monitoring the market for liquidity and deviations of price from fundamental value. AT consume liquidity when it is cheap and supply liquidity when it is expensive. AT contribute more to the efficient price by placing more efficient quotes and AT demanding liquidity to move the prices towards the efficient price.
TL;DR: In this paper, the authors considered the infinite-horizon optimal portfolio liquidation problem for a von Neumann-Morgenstern investor in the liquidity model of Almgren.
Abstract: We consider the infinite-horizon optimal portfolio liquidation problem for a von Neumann–Morgenstern investor in the liquidity model of Almgren (Appl. Math. Finance 10:1–18, 2003). Using a stochastic control approach, we characterize the value function and the optimal strategy as classical solutions of nonlinear parabolic partial differential equations. We furthermore analyze the sensitivities of the value function and the optimal strategy with respect to the various model parameters. In particular, we find that the optimal strategy is aggressive or passive in-the-money, respectively, if and only if the utility function displays increasing or decreasing risk aversion. Surprisingly, only few further monotonicity relations exist with respect to the other parameters. We point out in particular that the speed by which the remaining asset position is sold can be decreasing in the size of the position but increasing in the liquidity price impact.
TL;DR: This paper showed that transactions deposits help banks hedge liquidity risk from unused loan commitments, but only for banks with low levels of transactions deposits, and that this deposit-lending hedge becomes more powerful during periods of tight liquidity, when nervous investors move funds into their banks.
Abstract: Liquidity risk in banking has been attributed to transactions deposits and their potential to spark runs or panics. We show instead that transactions deposits help banks hedge liquidity risk from unused loan commitments. Bank stock-return volatility increases with unused commitments, but only for banks with low levels of transactions deposits. This deposit-lending hedge becomes more powerful during periods of tight liquidity, when nervous investors move funds into their banks. Our results reverse the standard notion of liquidity risk at banks, where runs from depositors had been seen as the cause of trouble.
TL;DR: This paper studied high-frequency exchange rates over 1993-2008 using a factor model to capture linear and non-linear linkages between currencies, stock and bond markets as well as proxies for market volatility and liquidity.
Abstract: We study high-frequency exchange rates over 1993-2008. Based on the recent literature on volatility and liquidity risk premia, we use a factor model to capture linear and non-linear linkages between currencies, stock and bond markets as well as proxies for market volatility and liquidity. We document that the (Swiss) franc and Japanese yen appreciate against the US dollar when US stock prices decrease and US bond prices and FX volatility increase. These safe haven properties materialise over different time granularities (from a few hours to several days) and non-linearly with the volatility factor and during crises. The latter effects were particularly discernible for the yen during the recent financial crisis.
TL;DR: In this article, the authors argue that the remarkable success of today's financial risk management methods should be attributed primarily to their communicative and organizational usefulness and less to the accuracy of the results they produced.
Abstract: Is the growth of modern financial risk management a result of the accuracy and reliability of risk models? This paper argues that the remarkable success of today’s financial risk management methods should be attributed primarily to their communicative and organizational usefulness and less to the accuracy of the results they produced. This paper traces the intertwined historical paths of financial risk management and financial derivatives markets. Spanning from the late 1960s to the early 1990s, the paper analyses the social, political and organizational factors that underpinned the exponential success of one of today’s leading risk management methodologies, the applications based on the Black–Scholes–Merton options pricing model. Using primary documents and interviews, the paper shows how financial risk management became part of central market practices and gained reputation among the different organisational market participants (trading firms, the options clearinghouse and the securities regulator). Ultimately, the events in the aftermath of the market crash of October 1987 showed that the practical usefulness of financial risk management methods overshadowed the fact that when financial risk management was critically needed the risk model was inaccurate.
Posted Content•
TL;DR: In this article, the authors discuss the notion of liquidity and liquidity risk within the financial system and distinguish between three different liquidity types, central bank liquidity, funding and market liquidity and their relevant risks.
Abstract: We discuss the notion of liquidity and liquidity risk within the financial system. We distinguish between three different liquidity types, central bank liquidity, funding and market liquidity and their relevant risks. In order to understand the workings of financial system liquidity, as well as the role of the central bank, we bring together relevant literature from different areas and review liquidity linkages among these three types in normal and turbulent times. We stress that the root of liquidity risk lies in information asymmetries and the existence of incomplete markets. The role of central bank liquidity can be important in managing a liquidity crisis, yet it is not a panacea. It can act as an immediate but temporary buyer to liquidity shocks, thereby allowing time for supervision and regulation to confront the causes of liquidity risk.
Posted Content•
TL;DR: In this article, the authors present evidence that these rates reached levels that cannot be explained alone by higher credit risk and provide a theoretical explanation which refers to the funding liquidity risk of lenders in unsecured term money markets.
Abstract: Unsecured interbank money market rates such as the Euribor increased strongly with the start of the financial market turbulences in August 2007 There is clear evidence that these rates reached levels that cannot be explained alone by higher credit risk This article presents this evidence and provides a theoretical explanation which refers to the funding liquidity risk of lenders in unsecured term money markets
TL;DR: In this paper, the authors provide a comprehensive empirical analysis of the effects of liquidity and information risks on expected returns of Treasury bonds, focusing on the systematic liquidity risk of Pastor and Stambaugh as opposed to the traditional microstructure-based measures of liquidity.
Abstract: We provide a comprehensive empirical analysis of the effects of liquidity and information risks on expected returns of Treasury bonds. We focus on the systematic liquidity risk of Pastor and Stambaugh as opposed to the traditional microstructure-based measures of liquidity. Information risk is measured by the probability of information-based trading (PIN). We document a strong positive relation between expected Treasury returns and liquidity and information risks, controlling for the effects of other systematic risk factors and bond characteristics. This relation is robust to many empirical specifications and a wide variety of traditional liquidity and informed trading proxies. Copyright (c) 2009 The American Finance Association.
TL;DR: In this article, interest margin determinants in the Russian banking sector with a particular emphasis on the bank ownership structure were analyzed using bank-level data covering Russia's entire banking sector for the 1999−2007 period, finding that the impact of a number of commonly used determinants such as market structure, credit risk, liquidity risk and size of operations differs across state-controlled, domestic-private and foreign-owned banks.
Abstract: This paper analyzes interest margin determinants in the Russian banking sector with a particular emphasis on the bank ownership structure. Using a unique bank-level data covering Russia’s entire banking sector for the 1999−2007 period, we find that the impact of a number of commonly used determinants such as market structure, credit risk, liquidity risk and size of operations differs across state-controlled, domestic-private and foreign-owned banks. At the same time, the influence of operational costs and bank risk aversion is homogeneous across ownership groups. The results overall suggest the form of bank ownership needs to be considered when analyzing interest margin determinants.