The Financial Crisis And The Liquidity Risk Finance Essay

October 1, 2017 February 4th, 2019 Music

Put merely, liquidness hazard is ‘the hazard stemming from the deficiency of marketability of an investing that can non be bought or sold rapidly plenty to forestall or minimise a loss ‘ ( investopedia ) . It is utile to find between two types of liquidness hazard: ‘funding liquidness hazard ‘ and ‘market liquidness hazard ‘ . The former describes the easiness of obtaining financess from other fiscal establishments or investors. Brunnermeier ( 2009 ) differentiates between three different types of ‘funding liquidness hazard ‘ : 1 ) rollover hazard, the possibility that it will be expensive or impossible to rollover short term borrowing 2 ) salvation hazard, the hazard that depositors withdraw financess and 3 ) margin/haircut support hazard. The latter respects a state of affairs where an plus is purchased and the purchaser uses the purchased plus as collateral and borrows short term against it. As the purchaser can non borrow the assets full monetary value, they must finance the difference ( the margin/haircut ) utilizing their ain equity capital. Traders tend non to transport much extra capital therefore, as margins/haircuts addition ; they must sell part/all of the plus. It is the same scenario if depositors begin retreating their financess. In order to rollover debt, fiscal establishments began to trust to a great extent on short term ( commercial ) paper ( repo contracts ) . This creates significant liquidness hazard as it is dependent on the market staying ‘awash with liquidness ‘ ( Brunnermeier, 2009 ) .

In each of the above scenarios, the liquidness hazard arises when the plus can merely be sold at fire-sale monetary values. This occurs when ‘market liquidness ‘ is low. The ‘market liquidness hazard ‘ represents the easiness of happening a purchaser. If liquidness is low so purchasers will be more hazard averse, as such, unwilling to pay above the odds for an plus. This depresses plus monetary values, farther increasing liquidness hazard. Typically, the hazard of assets is measured by their return relation to the hazard free return ( by and large the US Treasury Bill rate ) . In times of crisis this ‘interest rate spread ‘ widens due to the desire to keep ‘first rate collateral ‘ . In other words, the demand for US Treasury measures addition, dejecting the rate, whereas demand for hazardous assets fall, increasing the rate ( Brunnermeier, 2009 ) .

In July 2007, Chuck Prince ( Citigroup ‘s so CEO ) , summarised the significance of liquidness hazard in the fiscal crisis by pulling on Keynes ‘ analogy between bubbles and musical chairs:

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“ When the music stops, in footings of liquidness, things will be complicated. But every bit long as the music is playing, you ‘ve got to acquire up and dance. We ‘re still dancing. ” ( Nakamoto & A ; Wighton, 2007 ) .

There was a sensed decrease in liquidness hazard of Bankss in the old ages predating the crisis as they moved to a theoretical account of ‘originate and distribute ‘ , in add-on to financing their assets with short term adulthood instruments ( Brunnermeier, 2009 ) . The former was purportedly a method to offload hazard as it involved Bankss arising loans, e.g. residential mortgages, pooling these together into diversified portfolios, sliting these portfolios into ‘tranches ‘ ( each tranche represented a different degree of hazard ) , and so administering these loans ( in their new securitised signifier ) to assorted non bank fiscal establishments ( Goodhart ) . Liquidity hazard arises in this state of affairs for assorted grounds. First of wholly, as Bankss intended offloading the loans, they merely carried ‘pipeline hazard ‘ therefore had small incentive to take due attention in, processing and monitoring loan applications ( Brunnermeier ) . Second, these Collateralised Debt Obligations ( CDO ) were considered to be ‘off- balance sheet ‘ therefore were non included when finding a bank ‘s required capital ( set at 8 % under Basel I ) ( Goodhart ) . However, in world the bank ‘s hazard, through exposure to these SIV ‘s, was little changed. Often many of these securitised assets were held by conduits which, in bend, were owned by the bank ( Goodhart ) . In add-on, purchasers of these tranches could besides buy recognition default barters ( CDS ) which, in exchange for a fee, would see the purchaser against any default ( Brunnermier ) .

The construction of bank ‘s funding farther added to the climb liquidness hazard as the investing undertakings or mortgages ( which were typically long term investings ) were progressively financed with short term sedimentations. To keep funding for their conduits and SIV ‘s bank ‘s issued plus backed commercial paper ( ABCP ) , with typical adulthoods of 1 to 3 months ( Goodhart ) , making important support liquidness hazard if investors stopped purchasing ABCP. However, in the event that support for ABCP dried up, the commercial bank granted a ‘liquidity catcher ‘ , exposing the patronizing bank to important hazard that was non accounted for in the balance sheet ( Brunnermier ) . The addition in liquidness hazard through adulthood mismatch was besides as a consequence of repo contracts, which was frequently nightlong funding. Under repo contracts a house would raise financess by selling a collateral plus today with an understanding to buy back the plus in future ( Brunnermeir ) .

Due to the trust of bank ‘s on short term funding, any decrease in support liquidness would do important emphasis on the fiscal system. In summer 2007 we witnessed a dry up in liquidness for ABCP as investors struggled to value structured merchandises and assurance in evaluation bureau ‘s eroded ( Brunnermier ) . The changeless reduplication that the fiscal crisis was due to defaults on US subprime mortgages is apparent from figure 1 as, following an addition in defaults noted from February 2007, the market for mortgage backed securities collapsed where as other markets remained comparatively stable ( Brunnermeier ) .

As is apparent, liquidness hazard played a important function in the fiscal crisis and, due to the unfastened economic system the United States possesses and its place as a major fiscal participant, many other states and non US Bankss were exposed to the US subprime mortgage market. The UK was peculiarly exposed as RBS and Barclays were the two biggest investment bankers of mortgage backed securities in 2007. Both Bankss were besides large loaners of leveraged finance ( Timeonline ) . In add-on, HSBC and RBS ( through Citizens Bank ) have important presence in the United States. Other UK Bankss had less exposure to the US mortgage market, nevertheless, were to a great extent reliant on sweeping support therefore were susceptible to liquidness dazes e.g. HBOS ( TimesOnline ) .

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