Persistent noise, investors’ expectations, and market meltdowns
Giovanni Cespa, Xavier Vives, 22 April 2014
Since capital flows to and from hedge funds are strongly related to past performance, an exogenous liquidity shock can trigger a vicious cycle of outflows and declining performance. Therefore, ‘noise’ trades – usually thought of as erratic – may in fact be persistent. Based on recent research, this column argues that there can be multiple equilibria with different levels of liquidity and informational efficiency, and that the high-information equilibrium can under certain conditions be unstable. The model provides a lens through which to interpret the ‘Quant Meltdown’ of August 2007 and the recent financial crisis.
The recent financial crisis has revived interest in the question of what triggers crashes and meltdowns in financial markets. An important reason for abrupt and large price dislocations is the lack or ‘slow motion’ of arbitrage capital (Duffie 2010) that weakens the risk-bearing capacity of liquidity providers.
Topics: Financial markets
Tags: asset prices, financial crises, informational efficiency, liquidity, noise trading
Recent studies reinforce the case for the Liquidity Coverage Ratio
Stefan W Schmitz, Heiko Hesse, 28 February 2014
Europe aims to implement Liquidity Coverage Ratio regulation by the end of 2014. This column discusses recent evidence on its impact. It finds that EU banks have not adjusted by reducing lending to the real economy, to SMEs, or to trade finance. Despite this adjustment, substantial liquidity risk exposure remains. Overall, the benefits of the LCR outweigh the costs by far.
With the underpricing of liquidity risk prior to the crisis, a return to the same pre-crisis liquidity pattern is not expected. There is widespread consensus that banks’ extensive pre-crisis reliance on deep and broad unsecured money markets is to be avoided in the future (see e.g. IMF 2013).
Topics: EU institutions, Financial markets
Tags: banking, liquidity
A call for liquidity stress testing and why it should not be neglected
Clemens Bonner, 6 February 2014
Liquidity risks can be a primary source of bank failures. As such, there are arguments not to rely on a single metric for providing supervision. This column describes research on detailed cases of failed and near-failed institutions, which helps highlight gaps in current practices of liquidity stress testing. It also gives guidance on how to design liquidity stress tests. Deposit insurance coverage, the heterogeneity of lending commitments, distinction between different types of repos, committed facilities, and derivative transactions should receive increased attention when designing liquidity stress tests.
The recent financial crisis has shown that neglecting liquidity risks comes at substantial costs. In order to reinforce banks’ resilience to liquidity risks, the Basel Committee on Banking Supervision (BCBS) proposed the introduction of two harmonised liquidity standards:
Topics: Financial markets
Tags: banks, liquidity, stress tests
The determinants of banks’ liquidity buffers and the role of liquidity regulation
Clemens Bonner, Iman van Lelyveld, Robert Zymek, 1 November 2013
What are the determinants of banks’ liquidity holdings and how are these reshaped by liquidity regulation? Based on a sample of 7,000 banks in 30 OECD countries, this column argues that banks’ liquidity buffers are determined by a combination of both bank- and country-specific variables. The presence of liquidity regulation substitutes for most of these determinants while complementing the role of size and institutions’ disclosure requirements. The complementary nature of disclosure and liquidity requirements provides a strong rationale for considering them jointly in the design of regulation.
Until recently, liquidity risk was not the main focus of banking regulators. However, the 2007–2009 crisis showed how rapidly market conditions can change, exposing severe liquidity risks for some institutions. Although capital buffers were effective in reducing liquidity stress to some extent, they were not always sufficient.
Topics: Financial markets, Microeconomic regulation
Tags: banking, disclosure, liquidity, regulation, Too big to fail, transparency
The impact of liquidity regulation on monetary-policy implementation
Clemens Bonner, Sylvester Eijffinger, 14 October 2013
Liquidity requirements like the Basel III Liquidity Coverage Ratio are aimed at reducing banks’ reliance on short-term funding. This may have implications for the implementation of monetary policy, which usually operates through short-term interbank interest rates. This column looks at how banks reacted to the Dutch quantitative liquidity requirement. The authors conclude that liquidity requirements will only reduce overnight interest rates if they cause an aggregate liquidity shortage.
In response to the recent financial crisis, the Basel Committee on Banking Supervision has drafted a new regulatory framework (henceforth Basel III) with the aim to achieve a more robust banking system. While it also tightens the existing requirements for capital, the proposal stands out as it is the first to attempt harmonised liquidity regulation across the globe.
Topics: Financial markets, Monetary policy
Tags: BASEL III, financial regulation, liquidity, liquidity coverage ratio, monetary policy
Enhancing the global financial safety net through central-bank cooperation
Edwin M. Truman, 10 September 2013
Should we expect more global financial crises? This column argues that we should. Global financial crises are far from being a thing of the past because they are often caused by buildups of excessive domestic and foreign debt. To successfully address them and to limit negative spillovers, we need coordinated actions that prevent a contraction in global liquidity. Unless we establish this more robust, coordinated global financial safety net centred on central banks (which is where the money is), we may end up being incapable of addressing inevitable future crises.
The prospect that the Federal Reserve will soon ease off on its purchases of long-term assets has increased financial-market uncertainty and contributed to a retrenchment in global capital flows. This turbulence has revived discussion of the need to enhance the global financial safety net –i.e.
Topics: Global crisis, International finance
Tags: banking, Central Banks, debt, liquidity
Global factors in capital flows and credit growth
Valentina Bruno, Hyun Song Shin, 7 June 2013
‘Global liquidity’ focuses on the role of cross-border banking in the international transmission of financial conditions. This column argues that when global banks apply more lenient conditions on national banks by supplying wholesale funding, national banks transmit the more lenient conditions to their borrowers through greater availability of local credit. Researchers and policymakers would do well to recognise the role of global liquidity as a key concept in international finance.
It is a cliché that the world has become more connected, but the financial crisis and the boom that preceded it have focused attention on the global factors behind credit growth and capital flows.
Topics: International finance
Stock market turnover and corporate governance
Alex Edmans, Vivian W Fang, Emanuel Zur, 16 February 2013
The stock market is a powerful tool for controlling corporations’ behaviour. But which is better, a highly liquid market or a number of large blockholders? This column argues in favour of liquidity. Evidence suggests that policymakers should not reduce stock liquidity through greater regulation. While the idea that liquidity encourages short-term trading – rather than long-term governance – sounds intuitive, deeper analysis shows that liquidity is beneficial because it encourages large shareholders to form in the first place, and allows shareholders to punish underperforming firms through selling their stake.
The stock market is a powerful tool for controlling corporation’s behaviour. But what is best:
Topics: Financial markets
Tags: corporate governance, financial markets, firms, liquidity, stocks
Basel liquidity rules and their impact on the interbank money market
Clemens Bonner, Sylvester Eijffinger, 13 October 2012
Will the new Basel rules make monetary policy less effective? This column looks at how banks responded to the introduction of the Dutch quantitative liquidity requirement. It concludes that a liquidity rule does influence lending rates and volumes in the interbank money market. These effects, however, are at least partially intended and the overall effect of a binding liquidity rule is still positive.
Before the financial crisis in 2008, asset markets were liquid and funding was easily available at low cost.
Topics: Monetary policy
Tags: BASEL III, liquidity, liquidity coverage ratio
2nd MoFiR Workshop on Banking
The aim of the 2nd MoFiR Workshop on Banking is to bring together scholars in banking and finance to discuss the causes, transmission mechanisms, and consequences of the crisis, focusing also on the policy implications for the current situation and the potential reforms.
The organizing committee invites the submission of full papers or extended abstracts on the following themes:
• Financial sector fragility, contagion, safety nets, and crises;
• The (dis-)advantages of cross-border banking;
• Liquidity management and provision by financial intermediaries;
• Banks’ organizational models, informational asymmetries and distance;
• Bank lending, entrepreneurial finance and firm growth;
• Experiments in banking.
- Andrea F. Presbitero
- Ancona (Italy)
- Open attendance
- Università Politecnica delle Marche and MoFiR
- More information:
Disclaimer: Vox is not responsible for the accuracy of this information.
- Financial markets, Global crisis, Microeconomic regulation
- banking, foreign banks, liquidity, SME lending