Friday, 2 September 2011

Liquidity, Bank Capital and Market Reform

A friend forwarded some thoughts on liquidity that are worth sharing here, as liquidity is central to the utility of assets as bank capital and to stabilising markets under stress. My friend's points are in bold, with my commentary below.

Central bankers and securities regulators lost sight of liquidity over the past decade or two in permitting reforms which compromised the health of the financial system. Thanks to the Greenspan and Bernanke puts, and to surplus recycling by Asian economies, many took liquidity - like oxygen - for granted. Like oxygen, you only realise how critical liquidity is when its absence becomes noticeable.

Now that bank regulators have rediscovered liquidity as an essential attribute of healthy banks and healthy markets, it is important to reinforce some key qualities.

Liquidity means you can generate cash from a physical asset or paper claim.
If you can't exchange the asset for a major currency to meet a sudden funding need, then the asset shouldn't be permitted as regulatory capital. Basel II and Basel III have generated hundreds of pages around credit scoring and asset type while ignoring the fact that most of what banks are attributing as capital cannot be turned into cash on demand.

Liquidity can be gained by sale or repo of an asset, preferably in a transparent market. Where no market exists or the market has become illiquid, then liquidity must be gained through a central bank.
Virtually all RMBS markets failed under stress in 2008 and 2009, with failures spreading to other asset classes as investors grew wary of dealer spreads and perceived shallow dealer commitment levels. As the scope of funding problems grew, illiquidity spread to sovereign debt for troubled countries such as Greece and Portugal. Few OTC asset markets have recovered sufficient liquidity for dealing in size.

When the public markets will not price an asset in size without a large spread, then the central banks become the market makers of last resort. Without central bank repo of illiquid RMBS and sovereign debt, virtually every major bank in the OECD would have failed.

Because they now have the role of market maker of last resort, central banks should become much more active in ensuring that any asset permitted to be classed as capital by a bank can be liquidated on demand in a public market. Rather than leaving market structure to the investment banks and their tame securities regulators, the central banks should be driving forward reforms to ensure that capital assets are issued in fungible series, in size, and traded in transparent exchange markets with committed market makers.

This will require a major policy reversal on exchange regulation. Securities regulators have been under pressure for several decades to liberalise OTC markets, permit fragmentation to off-exchange trading systems, and turn a blind eye to issuance of securities in small, idiosyncratic offerings that will never liquidly trade except back through the offering investment banks. The quality assurance and market conduct functions of exchanges have been eroded following demutualisation, and exchanges now are run for profit of their highly concentrated owners rather than in the public interest.

Markets are at the heart of successful civilisations. Markets require quality norms, information publication, and price transparency to operate effectively. Regulators and investors allowed credit ratings to substitute for exchange listing rules and reporting requirements during the liquidity boom. Ratings were gamed by the banks until they were meaningless. We should now be forcing assets back onto exchanges and force the exchanges to regulate quality and information norms in the public interest. If this requires re-mutualising the exchanges, or public ownership of exchanges, then that should be on the agenda. Letting the exchanges be run by the thugs who gamed the markets and the rating agencies isn't healthy.

Liquidity means that proceeds of sale will be paid as funds to your account in a currency you can use widely to meet obligations.
If you can only sell your asset into a market denominated in a currency which itself is not liquid and not legal tender for meeting your obligations, then you haven't got liquidity vested in the asset. A lot of investors in emerging markets are probably going to find that liquidity in those markets is a lot less than they might think, despite advances in exchange trading of emerging market assets, and the currencies might be less liquid too in a falling market. If they require funding in their home currency, they risk taking a big hit on sale and FX spreads when they realise the asset under stress.

Liquidity is measured by size, speed and spread - not by price levels.
Whatever the market price, a market isn't liquid if those holding assets in size cannot deal in size. A market is not liquid if those holding assets cannot sell at the time the sell decision is made, but must wait to identify or attract sufficient buyers. A market is not liquid if the spread between the bid and ask is so wide that buyers will be deterred from the market by the risk of never recovering the spread in appreciation or returns. The way that markets have levitated on minimal volumes in 2010 and 2011 is no indication that the markets are liquid. As we've seen in August, even mild selling can have a massive effect on prices in an illiquid market.

Short sales are an attribute of liquid markets. If a market can't be shorted, then the market will fail as prices fall.
Short sellers will come in to buy assets in a falling market to realise a profit. They provide liquidity when everyone else is too scared to deal.

Securities markets regulators and central bankers need to think through liquidity as an attribute of market structure in the public interest. Idiosyncratic, illiquid, ill-transparent deals and instruments which have dominated market growth for the past two decades are behind the weakness of bank capital and market recovery. The regulatory incentives should be toward standardisation of securities terms and offering documents, much larger issues of securities and series of bonds, and fungibility of asset types within a class. Exchange trading should be encouraged, fragmentation discouraged. Exchanges should provide rigorous listing rules, timely reporting of market relevant information, full price transparency and two-way quote obligations on market makers. If we got that right, then much of the misrepresentation, mispricing, inefficiency and fraud of the past would become impossible in future.


Anonymous said...

Thanks for posting LB. Hope your doing well.

Richard said...

Thanks for focusing attention on liquidity. This issue is not focused on nearly enough.

The common feature to all assets that enjoy highly liquid markets is they provide all the useful, relevant information in an appropriate, timely manner to all market participants.

When market participants now what they are buying, they are much more likely to buy.

Knute Rife said...

It would seem we have insolvency generating illiquidity. For much of the last 10 years, and really for much of the last 20, liquidity has been maintained by credit "supported" by collateral that has proved grossly over-valued, especially real estate. It reached the point where new credit was simply servicing old credit because borrowers did not have revenue to service the old credit, which means that borrowers were in fact Ponzis. A slight breeze would have knocked it all over, and the option ARM resets of 2007 were a pretty stiff wind. Borrowers couldn't make the payments, and lenders discovered that a whole class of assets (payment streams) wasn't quite as copper-bottomed as projected. And when they looked at the other class (collateral), they saw those values dropping like shot quail as everyone attempted to liquidate assets at once. Then the shock wave moved up through the secondary markets and up and down the CDS chains, and everyone realized there simply weren't enough assets to cover all the liabilities that had been created. The system was insolvent. Further, everyone could see that assets would continue deflating, so they stuffed the cash in the mattress and froze it solid. With that, credit-driven liquidity died.

No amount of priming the liquidity pump by the central banks will fix that. The problem is that perhaps 80% of the population is insolvent by any honest definition, and in the face of such insolvency, there can not help but be more deflation. All the pump priming will just get stuffed into the mattress until we hit bottom.

Andrew Macpherson said...

Great piece and as always here great comments.

As an everyman on the outside looking in and trying to understand what is really happening in the economy, and what is coming down the pike, it looks like we as both the populace and the sovereign nations are drowning in a sea of debt from which the only way out is an extended period of the deflationary, deleveraging vortex.

Am I missing a happier, quicker solution to this global problem?

Anonymous said...

LB - Truly profound insights regarding liquidity. Thank you.

JakeS said...

Your central contention seems to be that it is desirable to demand that any security held on a bank balance sheet as regulatory capital must be liquid. This is a wholly superfluous requirement that will not enhance financial stability and do nothing to prevent crises like the present.

In a modern central banking system, any solvent, legally managed bank is able, under all non-crisis conditions, to access unlimited liquidity from the interbank market, at an overnight rate fixed by the central bank.

If a crisis causes the interbank market to break down, there can, ultimately, be three explanations:

a) The overwhelming majority of the banks usually able to access the interbank market have a solvency problem.

b) A substantial number of banks has solvency issues, and the market participants do not know which banks are solvent and which are not.

c) There is no substantial solvency problem and the interbank market participants are just being silly.

In the last case, demanding that bank assets are liquid does nothing for you that the central bank cannot do better at the discount window.

In the former two cases, the liquidity of bank assets does nothing to resolve the crisis that your financial regulator cannot do better by sending its forensic accountants into the books of the insolvent (or suspected to be insolvent) banks, to wipe out the bad assets. Once your financial regulator has painted a reality-based picture of the asset side of the insolvent bank's balance sheet, you decapitate the two or three topmost echelons of its management and wipe out the shareholders and however many of the bondholders you have to in order to restore solvency.

The bank can then be recapitalised by issuing common stock to the sovereign, issuing common stock into the private money markets, or subjecting the (now most junior) next tranche of bondholders to a forcible debt to equity swap.

If the bank's senior creditors included pension funds, important industrial concerns or other institutions that are of strategic importance to the country, but which are not covered by depositor insurance, the sovereign can then bail them out on a case-by-case basis (and should then revise its definition of "insured deposits" so it more accurately reflects the actual contingent liabilities of the sovereign in the event of a bank failure).

The insolvent bank is now solvent and under new management, and there is no further liquidity problem that the discount window cannot solve better than the private money markets.

- Jake

RebelEconomist said...

Sorry, I don't get this. You are right to emphasise the importance of liquidity, but it is not quite the same thing as solvency. If the aim of solvency regulation is to make sure that there is an excess of assets over liabilities (ie capital) which includes some solid assets to absorb losses in the event of a crisis for a particular institution, then the liquidity of those assets in extreme market conditions is not so relevant.

PeterJB said...



'Capital must protect itself in every possible way, both by combination and legislation. Debts must be collected, mortgages foreclosed as rapidly as possible. When, through process of law, the common people lose their homes, they will become more docile and more easily governed through the strong arm of the government applied by a central power of wealth under leading financiers.

These truths are well known among our principal men, who are now engaged in forming an imperialism to govern the world. By dividing the voter through the political party system [Republican/Democrat], we can get them to expend their energies in fighting for questions of no importance. It is thus, by discrete action, we can secure for ourselves that which has been so well planned and so successfully accomplished.'

Montagu Norman, Governor of The Bank Of England, addressing the United States Bankers' Association, New York, 1924.


PeterJB said...

“Banking was conceived in iniquity and was born in sin.

The Bankers own the earth. Take it away from them, but leave them the power to create deposits, and with the flick of the pen they will
create enough deposits to buy it back again.

However, take it away from them, and all the great fortunes like mine will disappear and they ought to disappear, for this would be a happier and better world to live in.

But, if you wish to remain the slaves of Bankers and pay the cost of your own slavery, let them continue to create deposits.”

Sir Josiah Stamp
(1880-1941) President of the Bank of England in the 1920′s, the second richest man in Britain, speaking at the Commencement Address of the University of Texas in 1927.

Mark said...

I find exchange based trading provides too much anonymity. In the days of open outcry floors it might have been possible to assess who was really doing what to whom, but in the modern electronic world all that has become truly opaque. If business is conducted through central counterparties, then only they and the originators know the risks being run and the degree of interest in short term manipulation to shake out smaller positions. In my experience, central counterparties are not the best overseers.

The customers of the banks need to know rather more than that they are "For carrying on an undertaking of great advantage; but nobody to know what it is".