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Market distress and vanishing liquidity: anatomy and policy options

  • Claudio E. V. Borio

Since the 1980s, a number of episodes of financial market distress have underscored the importance of the smooth functioning of markets for the stability of the financial system. At the heart of these episodes was a sudden and drastic reduction in market liquidity, characterised by disorderly adjustments in asset prices, a sharp increase in the costs of executing transactions and, in the most acute cases, a "seizing up" of markets. This essay explores the anatomy of market distress as well as the policy options to address it. It argues that, despite appearances, the genesis and dynamics of market distress resemble quite closely those of banking distress and that, contrary to conventional wisdom, the growth of markets for tradable instruments, and hence the greater scope to sell assets and raise cash, need not have reduced the likelihood of funding (liquidity) crises. At times of distress, in contrast to more normal times, risk management practices, funding constraints and counterparty risk become critical determinants of market liquidity. Articulating an appropriate policy response calls for an approach that takes full account of the interdependencies between the behaviour of market participants and market dynamics. To date, much useful work has been done to address market distress by improving the market infrastructure and the risk management at individual financial institutions. The territory that remains largely unexplored is precisely the link between the collective actions of individual market participants and market dynamics.

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Paper provided by Bank for International Settlements in its series BIS Working Papers with number 158.

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Length: 35 pages
Date of creation: Jul 2004
Date of revision:
Handle: RePEc:bis:biswps:158
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  1. John Y. Campbell & Sanford J. Grossman & Jiang Wang, 1992. "Trading Volume and Serial Correlation in Stock Returns," NBER Working Papers 4193, National Bureau of Economic Research, Inc.
  2. Michael J. Fleming & Eli M. Remolona, 1999. "Price Formation and Liquidity in the U.S. Treasury Market: The Response to Public Information," Journal of Finance, American Finance Association, vol. 54(5), pages 1901-1915, October.
  3. Jon Danielsson & Hyun Song Shin & Jean-Pierre Zigrand, 2004. "The impact of risk regulation on price dynamics," LSE Research Online Documents on Economics 16628, London School of Economics and Political Science, LSE Library.
  4. Michael J. Fleming, 2001. "Financial market implications of the federal debt paydown," Staff Reports 120, Federal Reserve Bank of New York.
  5. Helmut Elsinger & Alfred Lehar & Martin Summer, 2002. "Risk Assessment for Banking Systems," Working Papers 79, Oesterreichische Nationalbank (Austrian Central Bank).
  6. Miroslav Misina, 2003. "What does the risk-appetite index measure?," Economics Bulletin, AccessEcon, vol. 28(6), pages A6.
  7. Christian Upper, 2001. "How safe was the "Safe Haven"? Financial market liquidity during the 1998 turbulences," BIS Papers chapters, in: Bank for International Settlements (ed.), Market liquidity: proceedings of a workshop held at the BIS, volume 2, pages 241-266 Bank for International Settlements.
  8. T. Todd Smith & Garry J. Schinasi, 1999. "Portfolio Diversification, Leverage, and Financial Contagion," IMF Working Papers 99/136, International Monetary Fund.
  9. repec:ebl:ecbull:v:28:y:2003:i:6:p:a6 is not listed on IDEAS
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