Financial market liquidity and the lender of last resort

In the summer 2007, difficulties in the US subprime mortgage markets have led to disruptive developments in many financial market segments, in particular in interbank money markets, where central banks in the US and in Europe repeatedly intervened to restore smooth market functioning. This article investigates the circumstances in which liquidity shortages may appear in fi nancial markets and evaluates a number of options available to the lender of last resort wishing to restore fi nancial stability. It also suggests that the consideration of balance sheet data is not sufficient for evaluating the risks of leveraged financial entities. Instead, the analysis calls for an explicit consideration of collateral pledges, market illiquidity, and potential non-availability of market prices. Our main messages can be summarised as follows. First, we provide a clear hierarchy across policy alternatives. Taking a risk-efficiency perspective, it turns out that targeted liquidity assistance is preferable to market-wide non-discriminatory liquidity injections. In particular, when liquidity may be alternatively used for speculative purposes during the crisis, non-discriminating open market operations may attract unfunded market participants that divert funding resources away from its best uses in the financial sector. As a consequence, targeted liquidity assistance may become strictly superior. Second, we suggest that forced asset sales may lead to disruptive market developments in a context where financial investors are highly leveraged. Assuming away external funding or renegociability of debt contracts, a fully leveraged investor hit by a liquidity shock would have to liquidate some assets. When markets are not perfectly liquid, asset liquidation depresses market prices. Under standard risk management constraints, lower prices induce a re-evaluation of marked-to-market balance sheets, provoke margin calls, and trigger further selling. In the worst scenario, the leveraged investor may not be able to face the sum of liquidity outfl ows and subsequent margin calls. In that case, the market for illiquid assets breaks down, rendering the valuation of such assets an ambiguous exercise. For investors, such potential trading disruptions imply that the loss that triggers operational default is likely to be much smaller than suggested by standard risk measures.