Confronting the Coming Liquidity Crisis

The ECB s surprise liquidity operation put the continent s crisis on hold.

At the start, the Fed assumed that it was facing a first mode crisis a mere liquidity crisis and that the principal cure would be to ensure the liquidity of fundamentally solvent institutions.

First, the factors which allow a distinction to be made between liquidity and solvency problems are not clearly set. What determines a liquidity crisis?

Easier monetary policy may boost liquidity, but it will not resolve the solvency crisis.

Any financial crisis looks like a liquidity crisis for those who are stuck in the middle of it or anywhere nearby.

In at least one area, liquidity management, many investors learned painful lessons from the crisis.

If you believe that the crisis was caused by a shortage of liquidity, we had plenty of models analyzing liquidity shortages and their effects on financial institutions.

In response to the crisis, Asians sought to establish an Asian Monetary Fund, which would help any crisis hit country by providing massive liquidity assistance.

A second lesson is that dealing successfully with a financial crisis requires, most immediately, a strong dose of liquidity.

The report acknowledges that help without haircuts would be useful in a mere liquidity crisis resulting from dysfunctional markets.

The breakdown was fundamentally a liquidity crisis, and liquidity was easily restored in several ways the New York banks issued their own liquidity through a clearing house one massively powerful financial institution, J.P. Morgan, bought up collapsing shares, and thus reversed a market panic and a scramble for liquidity and European central banks supplied gold to the American market.

Before the crisis struck in 1998 he put in place measures giving him room to manipulate liquidity and interest rates.

Unlike the US, China did not suffer from a liquidity shortage and a credit crunch during the global financial crisis.

Although interest rates have been slashed and the Fed has lavished liquidity on cash strapped banks, the crisis is deepening.

Call it information liquidity, akin to financial liquidity.

These arrangements, most of which ended in 2010, responded to strains in short term credit markets and improved liquidity conditions during the crisis.

Having been burned by the crisis, banks have tightened their lending standards, and will now be subject to more stringent capital and liquidity requirements.

Even with their liquidity injections, the fallout from the financial crisis has eliminated the risk of a wage price spiral that might otherwise have arisen.

Many eurozone banks have made far less progress in strengthening their capital adequacy and liquidity than have American and British banks since the financial crisis erupted.

The 2008 global financial crisis revealed fundamental flaws in the international monetary system, as the failure to ensure sufficient liquidity weighed heavily on emerging Asian economies.

But by stubbornly arguing that that these countries are facing a liquidity crisis, rather than a solvency problem, euro officials are putting entire system at risk.

So 1907 became a comforting mantra in times of financial stress a crisis cannot happen as long as the central bank understands the problem of liquidity.

Is Liquidity Enough?

The Liquidity Puzzle

Europeans current crisis of confidence concerning Europe is far more dangerous than renewed market anxiety, because it cannot be overcome with another liquidity injection by the ECB.

At the time of the crisis itself, however, the main problem was not too much trading, but too little, as liquidity dried up for many financial transactions.

If a country faces payment problems, a mere liquidity crisis is to be assumed for the first two years, during which generous financial help would be available.

That has been precisely the problem with the aggressive provision of liquidity, quantitative easing, and the reduction of central bank interest rates used to address the current crisis.

Even an announcement by the Fed stating its willingness to do so would go a long way toward reassuring markets that emerging economies can avert a liquidity crisis.

The Liquidity Time Bomb

Indeed, the national central banks allocation of emergency liquidity assistance required approval by only one third of the Governing Council s members, and the six crisis countries had these votes.

Low debt and high liquidity should be valued for avoidance of cash flow distress, ensuring greater flexibility in adjusting asset allocation, and creating opportunities in the aftermath of a crisis.

The IMF recently established the Short Term Liquidity Facility to help strong performing members facing temporary liquidity problems.

In August 2007, the decision by BNP Paribas to close two of its hedge funds exposed to the subprime sector precipitated a liquidity crisis for all European banks during that summer.

The Chiang Mai Initiative agreed by the Finance Ministers of ASEAN 3 countries in May 2000 enabled emergency liquidity to be made readily accessible by member countries in times of crisis.

The third problem concerns international liquidity.

The fact that there is even a small liquidity crunch for banks implies larger liquidity crunches for less intensively regulated financial institutions, and even greater liquidity crunches for manufacturing and real estate companies.

These frightening numbers raise doubts about the stability of the West s financial system, and they dwarf all measures, such as bad banks and government guarantees, that attempt to solve a mere liquidity crisis.

The European Central Bank has provided a monetary lifeline that has provided much needed liquidity within the financial system and helped the government to stem the crisis of confidence created by the banking collapse.

The renminbi s rise over the past month can be attributed to greater global liquidity since the start of the third quarter, as policymakers have responded to the eurozone s sovereign debt crisis and stagnating output.

In brief, the major central banks on both sides of the Atlantic have responded to the financial crisis, but they have not overreacted. Even with their liquidity injections, the fallout from the financial crisis has eliminated the risk of a wage price spiral that might otherwise have arisen.

Such taxes surely reduce liquidity in financial markets.

This generates liquidity, which then stimulates GDP growth.

While Draghi s promise, embodied by the ECB s outright monetary transactions program as well as its long term refinancing operation and emergency liquidity assistance program has bought time and lowered yields, the eurozone s banking crisis persists.