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.
Volume (Year): (2008)
Issue (Month): 11 (February)
|Contact details of provider:|| Postal: Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS|
Web page: http://www.banque-france.fr/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Antonio E. Bernardo & Ivo Welch, 2004.
"Liquidity and Financial Market Runs,"
The Quarterly Journal of Economics,
Oxford University Press, vol. 119(1), pages 135-158.
- Antonio Bernardo & Ivo Welch, 2006. "Liquidity and Financial Market Runs," Yale School of Management Working Papers ysm280, Yale School of Management, revised 01 Aug 2003.
- Repullo, Rafael, 2000. "Who Should Act as Lender of Last Resort? An Incomplete Contracts Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 580-605, August.
- Rafael Repullo, 2000. "Who should act as lender of last resort? an incomplete contracts model," Proceedings, Federal Reserve Bank of Cleveland, pages 580-610.
- Repullo, R., 1999. "Who Should Act as Lender of Last Resort? An Incomplete Contracts Model," Papers 9913, Centro de Estudios Monetarios Y Financieros-.
- Jean-Charles Rochet & Xavier Vives, 2004. "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1116-1147, December.
- Rochet, Jean-Charles & Vives, Xavier, 2002. "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?," CEPR Discussion Papers 3233, C.E.P.R. Discussion Papers.
- Rochet, Jean-Charles & Vives, Xavier, 2004. "Coordination Failures and the Lender of Last Resort : Was Bagehot Right After All?," IDEI Working Papers 294, Institut d'Économie Industrielle (IDEI), Toulouse.
- Jean-Charles Rochet & Xavier Vives, 2002. "Coordination failures and the lender of last resort: was Bagehot right after all?," LSE Research Online Documents on Economics 24928, London School of Economics and Political Science, LSE Library.
- Jean-Charles Rochet & Xavier Vives, 2002. "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?," FMG Discussion Papers dp408, Financial Markets Group.
- Rochet, Jean-Charles & Vives, Xavier, 2002. "Coordination failures and the lender of last resort : was Bagehot right after all?," HWWA Discussion Papers 184, Hamburg Institute of International Economics (HWWA).
- Goodhart, Charles A.E. & Huang, Haizhou, 2005. "The lender of last resort," Journal of Banking & Finance, Elsevier, vol. 29(5), pages 1059-1082, May.
- Grossman, Sanford J & Miller, Merton H, 1988. " Liquidity and Market Structure," Journal of Finance, American Finance Association, vol. 43(3), pages 617-637, July.
- Grossman, S.J. & Miller, M.H., 1988. "Liquidity And Market Structure," Papers 88, Princeton, Department of Economics - Financial Research Center.
- Sanford J. Grossman & Merton H. Miller, 1988. "Liquidity and Market Structure," NBER Working Papers 2641, National Bureau of Economic Research, Inc.
- Xavier Freixas & Jean-Charles Rochet & Bruno M. Parigi, 2004. "The Lender of Last Resort: A Twenty-First Century Approach," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1085-1115, December.
- João A. C. Santos, 2006. "Insuring Banks Against Liquidity Shocks: The Role of Deposit Insurance and Lending of Last Resort," Journal of Economic Surveys, Wiley Blackwell, vol. 20(3), pages 459-482, 07.
- Mark J. Flannery, 1996. "Financial crises, payment system problems, and discount window lending," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 804-831.
- Flannery, Mark J, 1996. "Financial Crises, Payment System Problems, and Discount Window Lending," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 804-824, November.
When requesting a correction, please mention this item's handle: RePEc:bfr:fisrev:2008:11:14. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Michael brassart)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.