Liquidity of an asset has been defined as a degree where asset or security can be bought or sold in the securities market and this sale or purchase is done without harming the asset’s price. Liquidity has its own benefits such as investment in liquid assets than the illiquid ones. The liquid assets can be easily converted into cash which include the blue chip and money market securities. The ease and comfort with which financial instruments such as stocks and bonds are converted into ownership is the main essence of liquid assets (Burke, n.d.). Liquidity problems can arise due to the following business factors such as:
2. Liquidity problems affecting money market
Introduction
Liquidity of an asset has been defined as a degree where asset or security can be bought or sold
in the securities market and this sale or purchase is done without harming the asset‟s price.
Liquidity has its own benefits such as investment in liquid assets than the illiquid ones. The
liquid assets can be easily converted into cash which include the blue chip and money market
securities. The ease and comfort with which financial instruments such as stocks and bonds are
converted into ownership is the main essence of liquid assets (Burke, n.d.). Liquidity problems
can arise due to the following business factors such as:
Difficulty in paying bills- when a business is facing issues such as late payment of bills
then it indicates that the company is facing liquidity problems.
Current account ratio- it is one of the common ratios that usually indicates liquidity
problems. The higher the current ratio the better it shows that the company has adequate
liquidity.
Cash account ratio- since cash ratio is similar to the current ratio it therefore includes
cash and assets that can be easily convertible into cash. If the cash ratio is equal to one
then the company is in shortage of liquidity assets.
Profitability- every business needs to make profit in the long run and if a company is
unable to earn sufficient profit then it means that it is facing liquidity problems (Hamel,
n.d.).
Meaning of a bank run
A bank run is basically defined as the tenure when customers of a bank fear that the bank will
become insolvent in the future and this creates a panicky situation where the customers may
withdraw all the money quickly so that they may not loose on their money deposited with the
bank. Bank runs typically occur whenever the banks are in a situation of insolvency especially
when the amount in the demand deposit account decreases to a lower level than the estimated
one. Such insolvency situation may arise when the bank has paid more than the limit of paying
small fractions of deposits to the depositors. The system of demand deposits works well and
balances the financial situation of a bank unless a large number of people demand money and the
3. balance falls below a particular level. Bank run situation may lead to disruption in the trust of the
people who think that they may lose the money forever (Moffatt, n.d.).
Defining repo and reverse repo
A repurchase agreement also known as “repo” is basically a financial contract used by market
participants who use this financing method to meet the short and long term liquidity needs. A
noteworthy point is that repurchase agreements such as derivatives do not really end up in
bankruptcy of the party. A repo mainly transacts under two parts, firstly the transfer of securities
by one party whether it is the bank or borrower to another party in exchange for cash and
secondly it is the transaction costs of a contemporaneous agreement entered by the bank in order
to repurchase the securities at the original price itself (B. Gorton and Metrick, 2009). There are
no estimated statistics or figures which define what the actual size of a repo market is; therefore
it can be either $12 trillion or even an amount that is compared to be somewhere around $10
trillion as per the reports shown by the U.S Banking system. The process of keeping a track on
the growth of the securitized banking system can be done by comparing the figure of total assets
to that of the traditional growth of assets in the investment bank. The figures shown in the
growth of assets is noteworthy since it affects the repo finance rate more than the actual growth
rate of securitized banking system.
Repurchase agreement is also complimented with a reverse repurchase agreement. Repurchase
agreement has been defined as the selling of security along with the agreement to repurchase the
same security at a given price(B. Gorton and Metrick, 2009). A repo is therefore, defined to be
as a secured loan since this loan is given as cash against a security which is kept as collateral.
According to the borrower of cash, this can be considered as a reverse repo or reverse repurchase
agreement. Reverse repo is basically a mirror image of a repo agreement. In this case, securities
are purchased with a promise that the same would be resold simultaneously. This is the feature of
reverse repo unlike that of repurchase agreement. Investors use both repo and reverse
transactions to finance the securities which they hold in their investment as well as trading of
accounts is also required to be done as they help in establishing and implementing of activities
which is basically acquired in order to meet the specific customer needs and requirements (A.
Lumpkin, 1987).
4. Analysis of financial market crisis
Financial markets have experienced some really odd affairs that took place in the year 2007-
2008. One such event was the US subprime mortgage market which came under immense
pressure of the global money market. This crisis led to a great decline I the demand for asset-
backed securities. Credit loss and the assets were also written down with fall in prices and also
increased mortgage foreclosures as it was in the year of 2007 and 2008. The profit figure at US
banks decreased from $35.2 billion to $5.8 billion and this fall in profitable figure was seen in
the fourth quarter of the year 2007 (Claessens, Kose and Valencia, 2001).The main reason for the
global financial crisis of 2007-2008 is still a controversial topic and no one has still been able to
analyze the same. The major event that formulated as the financial crisis was the subprime
mortgage that was massive downgraded occurred as the mortgaged-backed securities by rating
agencies. Citibank also announced a seven structured investment vehicles in their balance sheet
as an amount of $49 billion. National Bureau of Economic Research had also declared as
business cycle peak so that there is a control on the financial events in the money market (Gorton
and Metrick, 2012).
The financial crisis and turmoil of the year 2007 and 2008 soon after the Great Depression had
rather threaten the existence of the real economy that provides good financial returns. The crisis
caused the economic mechanisms to lose out on the mortgage market and also showcased that
the economic threads could also work out in a better way to manage the decline in liquidity,
defaults, bailouts that could occur in the future money market as well. Most of the investors
usually invest in securities that have short maturity such as that of short term money market fund
(Chudik and Fratzscher, 2012). It so happens that funds also work for the short term money
market fund and financial crisis is the reasons why these short term money market fund perform
well in the market. The traditional banking system and the commercial banks have also financed
these short term loans with small deposit amount. The idea of using the off-balance sheet items
and investing the same in long term assets as well as in the short term assets explains how banks
fund liquidity risk. This sudden exposure to risk can also ensure that liquidity as well as the
credit line which comes in between the assets are for stopping liquidity. Structured financial
products were defined as the major part of the financial crisis along with mortgage back
securities and the investment also showed arbitrary ratings to the financial report (Chudik and
5. Fratzscher, 2012).The main reason for assuming liquidity risk diversification was the benefit
which was seen from using the AAA rated securities and its high valuations in the market which
helped the financial experts to decide on which is risk free and which are risky by nature.
How the crisis affected financial crisis
The rise in the security assets and the popularity of securitized products finally led to lesser
credit work and standards which fell at loss for the financial institution as well. On monitoring
risk and its features it was quite clear that there is urgent need to create proper prices for the
borrowers so that refinancing could earn some amount of money for the loan as well. The main
idea which triggered the liquidity crisis was the increase in the rate of subprime mortgage
defaults which was based on the swap prices of ABX index (K. Brunnermeier, 2009). Apart from
the structured products and the mortgage securities there were assets such as asset-backed
commercial paper which could value the ratings for the short term market and also non-asset
backed commercial paper could hardly suggests existence of the mortgage-backed securities.
There were a variety of market signals that clearly distinguished between the money market
participants and the financial experts. The anxious nature of the participants could also be seen
with that of average quoted interest rate on asset-backed commercial paper. There was a huge
shift in the interest rate from 5.39 percent to that of 6.14 percent during the financial crisis of the
year 2007. Rating agencies continued to decrease the various conditions and structured
investment vehicle was asked to operate at a normal level (K. Brunnermeier, 2009).
Analogy between crisis of 2007-2008 and traditional bank run
Great economist and researchers have drawn out an analogy between the liquidity problems that
took place in the year 2007-2008 and that of a traditional bank run. This analogy is presented
with securities such as asset backed commercial paper with that of how a bank traditionally runs
out. The analogy is that an asset based commercial paper faces a decline in the price or a loss
when the lenders who can also be treated as depositors in a bank are not ready to refinance such
commercial paper when the commercial paper comes nearer to its due date. The exact meaning
of a „run‟ is that the bank is unable to issue any new security be it even a commercial paper
despite considering the fact that there is minimum ten percent of the commercial paper at the
stage of maturing. As long as the crisis condition of the liquidity problems in the year 2007 and
6. 2008 is concerned, it was seen that there were a lot of instances of run in the market especially
during the month of August in 2007 (Gorton and Metrick, 2012).It was then noticed that by the
end of the year 2007, around 40 percent of the programs were in a situation of run and in such a
weak condition that they could not refinance themselves in the short term market.One major
similarity in both the crisis that was noticed was the wide leverage which was noticed in the
crisis. Soon after the crisis they were increase in housing prices as well. There was panic in the
banking system dye to such financial crisis. The asset backed commercial paper analysis shows
that any financial program is more likely to show its positive results if there is high credit risk
present instead. Therefore, it was noticed that runs are more vulnerable to the fundamentals of
the financial market whereas the investors are not even sure whether they are investing in a
strong market or even a weaker program. The analogy of both the financial crisis resulted in rise
of MMFs as they were expected to always be backed by their own sponsors. MMFs are basically
a super safe money instrument that needs no due diligence from its investors (Gorton and
Metrick, 2012).
Performance of other securities during financial crisis
The repurchase agreement which is also the repo market had experienced great degree of stress
as it survived itself during the financial crisis. The nonbank run on firms had also trusted on the
firms as long as the repo market analysis in the short term financing is concerned. There is a
liquidity constraint which is produced form vulnerable runs and a collateral constraint which is
vulnerable to fire sales available in the financial market. Moreover, it was rather uncertain that
there would be any contribution of the repo market in the financial crisis since the other markets
also faced a decrease in price during the same tenure as well (V. Murphy, 2013). Soon after the
financial crisis, the repo market was divided between three categories such as one that has
nonbanks relying on the repo transactions in order to conduct a financial regulation which is
exactly same as the safety and soundness policy of a firm. Secondly, reforms are required to be
made in the way repos are handled during a firm‟s failure. Lastly, there is also an urgent need to
change the techniques that are used in the repo trades especially those that increase technical
features of settlement system.
Non-bank intermediaries also experience quite a huge amount of liquidity constraint in the
mortgage crisis of 2007-2008. It so happened that during certain instances there was huge
7. financial disturbance regarding assessing the exact value of the complex mortgage securities in
an appropriate manner. It has been assumed that nonbanks would also resolve their issues
through bankruptcy process in which the financial creditors would also be treated equally. The
policy makers of the financial market also responded in two unique ways such as The Federal
Reserve had set up a special lending facility to support liquidity issues of the nonbanks (V.
Murphy, 2013). The second way in which the market showed a unique behavior was the lending
facility that was provided to avoid the bankruptcy filing of Bear Stearns and AIG instead of
solving the issue of Lehmann Brothers.
Securitization also faced a considerable change in its working pattern during the financial crisis.
The securitization aspect considered contribution to the magnitude of the financial crisis showing
different views on different behavior of the financial market. As soon as the credit losses took
place in the mortgage market the demand for mortgage backed securities also vanished
completely. A lot of mortgage finance companies also focused on selling the mortgage to
securitize it value but hey too failed in their attempt. Money market funds industry also faced a
huge crisis soon after the Lehmann Brothers episode took place in the year 2008 (V. Murphy,
2013). Emergency measures were taken into control so that the MMF could be stabilize and run
on the banks could be maintained. The treasury head announced insurance plans for MMF as it
was backed by the exchange stabilization fund which is a kind of fund available to the Treasury
so that they can stabilize the dollar price under the exchange rate system. Government also
provided its extended help to the development of the asset class during the crisis situation so that
there can be great encouragement towards facing excessive risks. On the lighter side it can be
said that the policy concerns have been constantly working towards the betterment and
improvement of the financial market that has seen funding being conducted through regulatory
approach towards banking and traditional securities (V. Murphy, 2013).
Conclusion
The financial crisis of the year 2007-2008 showed that banks need to create demand deposits so
that they can provide their investors with liquid assets which not only gives liquidity but also
solves a lot of issues related to urgent money requirement. It may happen that 40 percent of the
investors may be in need of urgent liquid money (W. Diamond, 2007). Therefore, the banks
would be able to help them out only if a reserve for liquid money is created in the banks in the
8. form of deposits. Demand deposits work very well as they are the main solution to the sudden
increased demand of investors and if there is a provision for maintain the liquidity then it is
easier to work out other issues of a bank as well. With the success of demand deposits, banks can
also analyze over initiating a similar kind of deposit with convertibility of deposits into cash.
Government policies will also be used to eliminate the self-fulfilling runs on the banks. The
government authority therefore plays a crucial role of being a taxation head which is normally
not available to the private firms (W. Diamond, 2007).
It has been made quite clear that the securities markets and firms work out the banking charters
as both being regulated and this has also been described as a new technique such as shadow
banking with certain federal regulation in place for the same. Banking regulation is traditionally
risk based but these securities have not been regulated in this mannerism. Securities regulation is
certainly not just fixed to the firms having special charter but also linked to the banking
regulation policy instead (V. Murphy, 2013). Bank holding companies also participate in the
course of understanding their prudential regulation which is more towards the consolidation
level. The modern liquidity management has also increase their reliability on the repurchase
agreement with which cash can also be used and exchanged as short term against the collateral
assets of longer maturities. The habit of introducing the liquidity assets and deposits in the bank
has increased and there is more liquidity providing operations instead (V. Murphy, 2013).With a
constant choice of collateral securities in place there is urgent need to select also the least risky
asset in the market which will let the borrower and lender to achieve the efficiency level of
sharing risk
Therefore, it can be concluded that the above analysis of the repo rate in the financial market and
the tedious condition of the financial crisis of the year 2007-2008 has suggested that the most
risky assets and the least liquid asset will remain deposited with the central bank in a much better
way. There is a rationale which one can move on with where there is absolute focus on the range
of assets which are being accepted as collateral securities (Ewerhart and Tapking, 2008). This
concept was also acknowledged during the study held for crisis management. The situation in US
was also quite different as the market started to react in a different way with measures available
in the market making it broader than a collateral base.
9. References
A. Lumpkin, S. (1987). REPURCHASE AND REVERSE REPURCHASE AGREEMENTS.
Instruments of the Maker Money, pp.15-16.
B. Gorton, G. and Metrick, A. (2009). SECURITIZED BANKING AND THE RUN ON REPO.
NATIONAL BUREAU OF ECONOMIC RESEARCH, pp.9-10.
Burke, A. (n.d.). The Definition of Liquidity in Finance. [online] Smallbusinesschron. Available
at: http://smallbusiness.chron.com/definition-liquidity-finance-36477.html [Accessed 10
Jan. 2015].
Chudik, A. and Fratzscher, M. (2012). LIQUIDITY, RISK AND THE GLOBAL
TRANSMISSION OF THE 2007-08 FINANCIAL CRISIS AND THE 2010-11
SOVEREIGN DEBT CRISIS. European Central Bank, pp.3-5.
Claessens, S., Kose, M. and Valencia, F. (2001). Financial Crises: Causes, Consequences, and
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Gorton, G. and Metrick, A. (2012). Getting Up to Speed on the Financial Crisis: A One-
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K. Brunnermeier, M. (2009). Deciphering the Liquidity and Credit Crunch 2007–2008.
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Ewerhart, C. and Tapking, J. (2008). Repo markets, counterparty risk, and the 2007 / 2008
liquidity crisis. European Central Bank, pp.37-39
10. Gorton, G. and Metrick, A. (2012). Getting Up to Speed on the Financial Crisis: A One-
Weekend-Reader Guide. Journal of Economic Literature, 1, pp.139-141
V. Murphy, E. (2013). Shadow Banking: Background and Policy Issues. Congressional Research
Service, p.23
V. Murphy, E. (2013). Shadow Banking: Background and Policy Issues. Congressional Research
Service, pp.16-19
W. Diamond, D. (2007). Banks and Liquidity Creation: A Simple Exposition of the Diamond-
Dybvig Model. Economic Quarterly, 93(2), p.199