Saturday, April 25, 2009

>Flash Economics (ECONOMIC RESEARCH)

The importance of financial market liquidity for banks

The crisis has been characterised by the disappearance of liquidity in most financial markets. In this Flash, we look at the aspects that concern banks and the issues they give rise to:

• the first problem (to a greater extent for retail banks) is the disappearance of liquidity in the markets where banks raise funds (interbank, certificates of deposit, senior debt, covered bonds, ABS, etc.). This leads to an all the more serious problem when the intermediation position of banks is more substantial (i.e. the duration of assets is longer than the duration of liabilities);

• the second problem (to a greater extent for investment banks) is the disappearance of liquidity in the markets of assets held by banks, in particular via trading. This prevents the sale of these securities and forces banks to raise funds on a durable basis and not a transitory one (and this can spark a liquidity crisis) and means they need to be provisioned.

One could envisage a "radical" solution that would consist in:

• demanding banks have a small duration gap; but the role of banks consists in transforming short-term savings into long-term loans and this role disappears if they are not allowed to have a duration gap;

• slashing the size of trading books; but there is a vicious circle here: trading ensures market liquidity, and a ban on trading therefore leads to a problem.

If one does not want to use this radical solution, and therefore if one wants to allow retail banks to have a duration gap and investment banks to have trading operations, the only solution is for other economic agents to ensure liquidity in financial markets.

However, ensuring the liquidity of assets used by banks to finance themselves suffices, since then banks can finance their trading books even if the assets they hold (other than bank financing assets) become illiquid.

The last issue is how liquidity can be ensured in the markets of assets that finance banks. We would suggest:
• extending the government guarantee of deposits to these assets;
• give the role "of a buyer of last resort" of these assets to the central bank.

The crisis has been characterised by the appearance of massive risk premia in all financial markets, which result from the rise in default risk premia, but above all from the very strong increase in illiquidity risk premia, which stems from the virtual disappearance of liquidity from secondary asset markets, and explains why there are spreads that cannot be explained by default risk on its own.

To see full report: FLASH ECONOMICS