The Financial Crisis and the Liquidity Risk Finance Essay

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Put simply, liquidity risk is ‘the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss’ (investopedia). It is useful to determine between two types of liquidity risk: ‘funding liquidity risk’ and ‘market liquidity risk’. The former describes the ease of obtaining funds from other financial institutions or investors. Brunnermeier (2009) differentiates between three different types of ‘funding liquidity risk’: 1) rollover risk, the possibility that it will be expensive or impossible to rollover short term borrowing 2) redemption risk, the risk that depositors withdraw funds and 3) margin/haircut funding risk. The latter regards a situation where an asset is purchased and the buyer uses the purchased asset as collateral and borrows short term against it. As the buyer cannot borrow the assets entire price, they must finance the difference (the margin/haircut) using their own equity capital. Traders tend not to carry much excess capital thus, as margins/haircuts increase; they must sell part/all of the asset. It is the same scenario if depositors begin withdrawing their funds. In order to rollover debt, financial institutions began to rely heavily on short term (commercial) paper (repo contracts). This creates substantial liquidity risk as it is dependent on the market remaining ‘awash with liquidity’ (Brunnermeier, 2009). In each of the above scenarios, the liquidity risk arises when the asset can only be sold at fire-sale prices. This occurs when ‘market liquidity’ is low. The ‘market liquidity risk’ represents the ease of finding a buyer. If liquidity is low then buyers will be more risk averse, as such, unwilling to pay above the odds for an asset. This depresses asset prices, further increasing liquidity risk. Typically, the risk of assets is measured by their return relative to the risk free return (generally the US Treasury Bill rate). In times of crisis this ‘interest rate spread’ widens due to the desire to hold ‘first rate collateral’. In other words, the demand for US Treasury bills increase, depressing the rate, whereas demand for risky assets fall, increasing the rate (Brunnermeier, 2009). In July 2007, Chuck Prince (Citigroup’s then CEO), summarised the significance of liquidity risk in the financial crisis by drawing on Keynes’ analogy between bubbles and musical chairs: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (Nakamoto & Wighton, 2007). There was a perceived reduction in liquidity risk of banks in the years preceding the crisis as they moved to a model of ‘originate and distribute’, in addition to financing their assets with short term maturity instruments (Brunnermeier, 2009). The former was supposedly a method to offload risk as it involved banks originating loans, e.g. residential mortgages, pooling these together into diversified portfolios, slicing these portfolios into ‘tranches’ (each tranche represented a different level of risk), and then distributing these loans (in their new securitised form) to various non bank financial institutions (Goodhart). Liquidity risk arises in this situation for various reasons. First of all, as banks intended offloading the loans, they only carried ‘pipeline risk’ thus had little incentive to take due care in approving, processing and monitoring loan applications (Brunnermeier). Secondly, these Collateralised Debt Obligations (CDO) were considered to be ‘off- balance sheet’ thus were not included when determining a bank’s required capital (set at 8% under Basel I) (Goodhart). However, in reality the bank’s risk, through exposure to these SIV’s, was little changed. Often many of these securitised assets were held by conduits which, in turn, were owned by the bank (Goodhart). In addition, buyers of these tranches could also purchase credit default swaps (CDS) which, in exchange for a fee, would insure the buyer against any default (Brunnermier). The structure of bank’s financing further added to the mounting liquidity risk as the investment projects or mortgages (which were typically long term investments) were increasingly financed with short term deposits. To maintain financing for their conduits and SIV’s bank’s issued asset backed commercial paper (ABCP), with typical maturities of 1 to 3 months (Goodhart), creating significant funding liquidity risk if investors stopped buying ABCP. However, in the event that funding for ABCP dried up, the commercial bank granted a ‘liquidity backstop’, exposing the sponsoring bank to significant risk that was not accounted for in the balance sheet (Brunnermier). The increase in liquidity risk through maturity mismatch was also as a result of repo contracts, which was often overnight financing. Under repo contracts a firm would raise funds by selling a collateral asset today with an agreement to repurchase the asset in future (Brunnermeir). Due to the reliance of bank’s on short term financing, any reduction in funding liquidity would cause significant stress on the financial system. In summer 2007 we witnessed a dry up in liquidity for ABCP as investors struggled to value structured products and confidence in rating agency’s eroded (Brunnermier). The constant reiteration that the financial crisis was due to defaults on US subprime mortgages is evident from figure 1 as, following an increase in defaults noted from February 2007, the market for mortgage backed securities collapsed where as other markets remained relatively stable (Brunnermeier). As is evident, liquidity risk played a significant role in the financial crisis and, due to the open economy the United States possesses and its position as a major financial player, many other countries and non US banks were exposed to the US subprime mortgage market. The UK was particularly exposed as RBS and Barclays were the two biggest underwriters of mortgage backed securities in 2007. Both banks were also big lenders of leveraged finance (Timeonline). In addition, HSBC and RBS (through Citizens Bank) have significant presence in the United States. Other UK banks had less exposure to the US mortgage market, however, were heavily reliant on wholesale funding thus were susceptible to liquidity shocks e.g. HBOS (TimesOnline). https://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article3572658.ece

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