Liquidity Definition

Liquididty Definition

Non-technical outline

Financial liquidity is an elusive notion, nonetheless of paramount importance for the well-functioning of the Financial system. In fact, the events in Financial markets since August 2007 bear all the hallmarks of increased funding liquidity risk, however conjointly reveal how this kind of risk will contaminate market liquidity and necessitate reactions from central banks. This project combines literature on liquidity from varied Fields of research during a schematic and holistic manner in order to provide a uniFied and consistent account of Financial system liquidity and liquidity risk. The outcome of this e¤ort reveals the subsequent:

Three main liquidity notions, namely central bank liquidity, market liquidity and funding liquidity are deFined and mentioned. Their advanced and dynamic linkages will give us a sensible understanding of the liquidity workings in the Financial system and reveal positive or negative e¤ects for Financial stability, depending on the degree of liquidity risk prevailing.

The causes of liquidity risk lie on departures from the complete markets and symmetric data paradigm, that can cause moral hazard and adverse selection. To the extent that such conditions persist, liquidity risk is endemic in the Financial system and will cause a vicious link between funding and market liquidity, prompting systemic liquidity risk. It is specifically this type of market risk that sometimes alerts policy manufacturers, as a result of of its potential to destabilise the Financial system.

In such cases emergency liquidity provisions will be a tool to restore balance. The central bank has the power and the obligation to minimise the important prices of liquidations and the chance of a Financial system meltdown. However, the role of central bank liquidity in such turbulent periods will not have guaranteed success, because it cannot tackle the roots of liquidity risk. In fact, the potential beneFits are limited by the actual fact that the central bank cannot distinguish between illiquid and insolvent banks with certainty. Therefore, it ought to only specialise in halting (temporarily) the vicious circle between funding and market liquidity. The tradeo between the beneFits and costs of intervention ought to be taken under consideration when the central bank has to choose on its liquidity providing strategy. This task is not straightforward and there's no established rule of thumb.

So as to eliminate systemic liquidity risk, greater transparency of liquidity management practices in required. Supervision and regulation are the fundamental weapons against systemic liquidity risk. These practices will tackle the basis of liquidity risk by minimising uneven info and ethical hazard through e¤ective monitoring mechanisms of the Financial system. In this way it is easier to differentiate between solvent and illiquid agents and therefore impose liquidity cushions to those most in need. This would additionally facilitate markets become more complete. But, such mechanisms can be expensive, due to the quantity of data that must be gathered. They should, so, be run by the most value e¢ cient and result-e¤ective agent.
Technorati Tags: liquidity definition