Presented by :

Mohd Khairulrizal bin Rosley

Zaki bin Aman

LIQUIDITY CRISESBY

RONEL ELUL – SENIOR ECONOMIST IN RESEARCH

DEPARTMENT OF PHILADEPHIA FED.

a) Introduction

b) Factors Financial Crises

c) Main Features That Occur Due To The Liquidity Crisis

d) Government Intervention To Solve Liquidity Crisis

e) Conclusion

Contents

INTRODUCTION

Liquidity Crises A sudden and prolonged evaporation of both market and funding liquidity, with potentially serious consequences for the stability of the financial system and economy.

Liquidity Term used to describe how easy it is to convert assets to cash.

INTRODUCTION

• Long-Term Capital Management (LTCM) was a very large hedge fund ($126 billion in assets) that nearly collapsed in late 1998.

• The founder was a Salomon Brothers trader, John Meriwether, and the principal shareholders were Nobel prize-winning economists Myron Scholes and Robert Merton.

• These were all experts in investing in derivatives to make above-average returns and outperform the market

• U.S. and world financial markets found themselves facing a possible financial crisis, and the U.S. Fed found itself during a difficult scenario.

• turning into clear that banks and alternative financial establishments would ultimately lose tens or perhaps many billions of greenbacks from their exposure to subprime mortgage market loans.

• Bank loaning is closely tied to bank capital or internet worth—specifically, bank regulators need that loans not exceed an exact multiple of capital. Thus, the Fed moon-faced the danger of a pointy contraction in credit and bank loaning during a approach that vulnerable a deep recession or worse.

Con't

LTCM Financial Market 2007

Factors of Financial Crises

Some money have very little impact outside of the money sectorSome third generation model s of currency crises explore however currency crises and banking along will cause recession

The risk related to debts and assets don’t seem to be fitly aligned The couple between the bank short run liabilities ( its deposit ) and its semipermanent assets ( its loan ) is seen in concert of explanations bank runs occur

Borrowing to finance investmentHowever may lose over all itsConjointly creates a risk of bankruptcyImply that a firm fails to honor all its secure payments to differentCompanies, its going to unfold money troubles from one firm to others

Major goal of regulations is transparency, creating institution money things publically famous by requiring regular reportage underneath standardize accounting procedures Regulator failure to protect against excessiverisk taking within national economy. Fraud in mortgage funding as their managerdid not do their fiduciary duties

o Investment mistakes caused by lack of information or the imperfections of humanreasoningo Herd behavior causes cost to spiral up wayon top of truth worth of the assets, a crash might become inevitable

Liquidity crisis might unfold from one establishment to a different as one bank withdraw spreads from some bank to

several other, or from one country to other.Once the failure of specific establishment threatens the steadiness of the many different establishments is often know as general risk

ANALYZING ISSUE

MAIN FEATURES THAT OCCUR DUE TO THE LIQUIDITY CRISIS

FLIGHT TO QUALITY

• A Movement by investor to buy higher quality security

• Occur when a deteriotion in politic stability or in economic activity

• Bank preserve their liquidity and cut back on lending

Brunnermier & Pederson Model (1998) • Liquidity scarce – market participant prefer to

conserve it by investing in less risky assets

• Liquidity problem spread to other market• Price continue decline-

breach agreement and force selling will occur• Financial constraint –

difficult to borrow

affect the value

Bank- as main player to improve funding

LIQUIDITY SPIRAL

Lasee H.P model ( 2008 )

• Recapitalise-

raising new capital

diluting old equity

possibly reduce face value of old debt

broadening bank guarantee

opening the Feds discount window

ensure the Commercial Paper market function

Cont

• Failure financial instrument have fueled financial market turmoil.

• Borrower default on his loan – lender fail to provide liquidity to meet operational cost or return to fund providers

Financial intermediation- accept assets that inherently illiquid and offer liability which

are much liquidity- make bank vulnerable to a bank run

SUBPRIME MORTAGE DEFAULT

Diamond-Dybvig model (1983)

• Emphasizing the role played by demand deposit contract-

provide liquidity , better sharing among

people , potential undesirable equilibrium

depositors panic and withdraw their deposit

• Liquidated assets sold at loss- bank also will liquadated all the asset even if not all depositors withdraw

Cont

• Liquidity crisis continue worsen

• Bank take carefully action-

reduce provision of liquidity in market

hoarding the liquidity to prepare second wave

Trading require capital

Trader buy security and use as collateral to borrow against but cannot borrow at the entire price

LIQUIDTY HOARDING

Markus K. B and Lasse model ( 2008 )

• Margin/haircut – difference between security price and collateral value – so balance must be finance with the trader own money

• Funding liquidity unavailable- trader reluctant to take position especially in high margin securities

• low future liquidity increase the risk of financing a trade, thus increasing margin

Cont

• Investor need fund to operate and raise fund from the financial institutional

• Fail provide fund- price declining because investor not enough fund and the seller will lower the price to induce the investor to buy with limited source.

• Scarce liquidity – suffer losses in other activities or not provided efficiency

• Lender unwilling to offer sufficient fund

THE FAILURE OF FINANCIAL INSTITUTIONS PROVIDE THE LIQUIDITY FUND

• Tightened lending standard and terms –

to avoid own losses or exposure

• Deterioration in their parent bank capital position

Cont

Federal Reserve Board ( 1998 )

SUGGESTION / RECOMENDATION

Taxing consumer Printing money

Role for Policy Pre-Emptive or Ex-Ante Policy Imposition of minimum equity Exposit Policy Intervention Some experts suggest that the

Central Bank should provide downside insurance in the event of a liquidity crisis.

GOVERNMENT INTERVENTION TO SOLVE LIQUIDITY CRISIS

4.1 Provide liquidity in time of crisis

• The ambiguous weapon system nature of liquidity provision by central banks

Given the potential limitations of alternative tools, a good financial institution framework to provide liquidity to the national economy could be a necessary part of arrangements to handle liquidity crises.

• The need to develop principles for the availability of financial institution liquidity

• By now, there's a fairly well developed set of principles for the way to handle the failure of individual establishments and therefore the corresponding supporting role of emergency (funding) liquidity.

The desirability of fitting place (variable) speed limits

This follows from the chance that rising the monetary infrastructure, like PSS, and introducing buffers, like within the sort of minimum capital and liquidity ratios, might fail to act as a brake within the growth section

• The role of payment and settlement systems (PSS)

The role of PSS is vital as a result of, if badly designed, they will exacerbate liquidity crises once they go on.

• The role of (retail) deposit insurance schemes

Of specific concern is that the chance of runs on otherwise solvent establishments that would cause them to fail.

• The growing reliance on funding liquidity in a very market-based national economy

Many observers expected the event of markets to scale back the reliance on funding liquidity, within the sense of dependence on external funding.

• The individual and systematic parts of liquidity crises

• a) The First Common -the dynamics of liquidity crises could be a reciprocally reinforcing feedback between market liquidity, funding liquidity and counterparty risk – or credit risk .

• b) The second common feature is that liquidity crises don't seem to be like meteor strikes; rather they are the endogenous results of the build-up in risk-taking and associated overextension in balance-sheets over a protracted amount – what could be termed the build-up of monetary imbalances

• The need to enhance buffers

Continuing with the analogy with policies towards road safety, this effectively suggests that put in place higher buffers, like automotive bumpers and guard-rails

• The global monetary crisis has beat home the importance of the evaporation of liquidity within the dynamics of monetary distress.

• Policies aimed toward preventing associate degree addressing such crises hare regained an urgency that they had lost for a few time (Goodhart (2007)).

• A lot of reflection and soul looking out is beneath means in each policy and personal circles.