A capital market is said to be liquid if securities can be bought and sold in that market at any time, in both small and large amounts, without any noticeable premiums or discounts on fair market prices. Economists use certain indicators to show that liquidity in the capital market has increased, decreased, or remained the same.
Liquidity underpins the market’s ability to buy or sell commodities and securities in established exchanges and derivative products (options, futures, swaps, and so on) at a competitive price at any time with any chosen counterparty. It should, however, be remembered that every market and every financial instrument has liquidity characteristics of its own. While the futures market may be liquid, very large orders might have to be broken down into smaller ones to prevent an adverse price change.
Other criteria also help in the measurement of market liquidity and its sustenance. For this rea- son, measures of market liquidity must consider the spread, depth, and price impact of trades in addition to liquidity’s implications for trading and the management of risk. It is also important to examine the role of:
• Transaction time
• Number of transactions made
• Transaction volume
• Volatility in liquidity and liquidity predictions
Liquidity can become the key element in the risk profile of any entity and of every one of its positions. The problem is that the method by which financial institutions and industrial companies address the issue of liquidity produces many unreliable responses because of their tendency to mix different distinct factors addressing liquidity, such as market liquidity and transaction liquidity.
In principle, it is wise to differentiate between liquidity in a general market sense and an entity’s own liquidity, or illiquidity in terms of not meeting liabilities as they fall due, which is default. In connection with market liquidity, management has to adjust its business activities, but to do so it needs information about what a normal and an abnormal market-size trade is plus a wealth of spe- cific spread data relating to what is considered to be acceptable market size. In the case of listed
securities, for example, one of the indicators of increased liquidity is a noticeably higher volume of individual issues.
The use of ratios, modeling, and experimentation, in the sense discussed in Chapter 7, is impor- tant because adequate liquidity is a prerequisite for ensuring that financial resources are transferred without friction and without surprises. This transfer depends not only on well-balanced suitable institutional arrangements but also on stable supply and demand conditions.
During economic phases in which there is a dearth of willing counterparties, owing to one-sided transactions by banks and institutional investors, general market illiquidity sees to it that large price movements occur even in market segments that are otherwise considered liquid. As a rule, techni- cal measures to improve market liquidity are no substitute for a longer-term perspective taken by capital market players. It is important to remember that:
• In the longer term, the market tends to be liquid.
• Illiquidity spikes do not last long, but when they come they can be devastating.
Senior management should be prepared to face the aftermath of illiquidity at any time for any reason it may arise. It also should understand that in the last analysis, the market is the arbiter of liquidity or illiquidity. The market system performs best when credit institutions execute their inter- mediation action in full appreciation of the fact that they are an integral part of the liquidity equa- tion and of the recycling of money that underpins it.
DIFFERENT TYPES OF MARKET LIQUIDITY AND MONEY SUPPLY
Liquidity and leverage correlate in a negative way. The same is true about credit quality and lever- age. According to Henry Kaufman, in the 1980s the corporate leveraging explosion was accompa- nied by a severe drop in corporate credit quality. Kaufman adds: “Among other things I believe that highly leveraged firms ran a good chance of reporting higher-than-normal losses during the cycli- cal downturn in the economy.”1
Highly leveraged firms may go bust in a market liquidity crisis or at least find it difficult to exe- cute new transactions necessary to balance liabilities versus assets. They cannot function properly to take advantage of business opportunities or for hedging reasons. Yet money is the raw material of banks, and as market theory teaches, there are many ways that we might split up the demand for money. One breakdown, which over the years has been found to be convenient, was originally pro- posed by Dr. Paul Samuelson. It divides demand for money into two major classes:2
• Liquidity for transactions,where money is needed to facilitate ordinary purchases of goods and services, or for trading reasons.
Note that depending on the type of transaction, this class takes a certain amount of money out of circulation or, alternatively, injects money into the market. Intermediation by banks works in both ways, with credit institutions contributing to:
• Market liquidity proper. This demand for money aims to hold part of the wealth in a form whose
Market Liquidity and the Control of Risk
In general, liquid money is active moneywith a fairly high velocity of circulation. The velocity of circulation creates the liquidity in a market that permits financial institutions, other companies, and investors to make transactions as well as to face unforeseen contingencies. Like any central bank, the Federal Reserve can inject liquidity into the market by:
• Lowering the interest rate, which makes money cheaper
• Promoting easy money through open marketoperations
For instance, the Fed buys bonds from investors and commercial banks, paying for them by money it prints and by its checks. As a result, interest rates fall and bond prices rise. Investors who have sold bonds will be holding more cash. They will look at common stocks and consider them a better buy than bonds with reduced yield. This happened at the New York Stock Exchange after the 1995 $52 billion rescue plan for Mexico, as the money got recycled into the United States.
Tempting investors to buy shares boosts the price of equities and lowers their yield, making it easier for businesspeople to raise capital. For their part, commercial banks end up with higher excess cash reserves than before. Therefore:
• They will be more lenient in lending.
• Competition will drive down interest rates on mortgages and business loans.
There are other aftermaths of market liquidity: Capital formation will rise and the stock of cap- ital will grow. The national product also will grow, but so will wages, with this eventually translat- ing into inflation. While interest rates and property yields will fall, total property earnings will rise or fall depending on elasticity or inelasticity in market demand. Classical economics considers mar- ket liquidity to fit well with the concept of market efficiencybecause it assumes that, by definition, an efficient market is one that:
• Is very large
• Has many players
• Has someone to look after it (the reserve bank)
But due to the globalization of markets, this theory is no longer valid. Even the United States, which is a large market with many participants, does not fit the classic description as American investors turn their thrust toward Mexico, Turkey, Indonesia, and other emerging markets—markets that, incidentally, are outside the Fed’s jurisdiction.
One of the crucial issues that still is in need of factual and documented answers is the connec- tion between market heterogeneityandmarket inefficiency. The two are not the same, but neither are they independent from one another. A great deal more research is necessary, particularly in con- nection to ephemeral inefficiencies.
Let us now turn to a concept introduced earlier: the velocity of circulation of money,v. It impacts most significantly on the money, and it is never constant. If MS stands for money supplyand MB for monetary base(the sum total of all paper money and coins issued by the reserve bank, also known as M0)3, then:
There are different metrics for money supply, from M1to M9. M1is the more limited definition of money supply, representing the money that can be spent right away; it represents the gross sum of all currency and demand deposits held by every consumer and business in a country. Checking account deposits are about three-quarters of M1; hence M1is much larger than M0.
The Fed targeted M1for many years. Then it switched to M2, which is equal to M1plus time deposits in the banking system. Like M1, M2varies over time in relation to reserve bank policies, investment policies, propensity to consume, and other factors. As Exhibit 8.1 shows, from January to March 2001 the money supply exploded, rising at a 12 percent annual rate. The last time M2
surged at a similar pace was in late 1998, in the aftermath of the Russian bond default and the col- lapse of Long Term Capital Management.
Other central banks use different metrics. For instance, the German Bundesbank tracks M3, which includes: currency in circulation, demand deposits with banks, demand deposits with postal giro system, time deposits, and savings deposits.
No matter which metrics the monetary authorities follow, rapid growth in supply of money can lead to inflation. Money supply is increased by increasing either the monetary base or the velocity of circulation of money, or both. Not only the reserve bank but also the banking sector as a whole impacts on the money supply. The quantity theory of money links money supply to gross national product (GNP):
Exhibit 8.1 The Rapid Growth of M2in a Matter of Three Months (January to March 2001)
RA TE OF M2 GR O W TH
(NO TE D IFFE R ENCE )
(NOTE DIFFERENCE)
MS = MB • v
GNP = P • Q where:
P = price level
Q = output of the economy
Market Liquidity and the Control of Risk
Money supply impacts on the output of the economy as well as on the price level. The algorithm to remember is that credit, and therefore debit, and money supply grow together. When added to the monetary base, the banking system’s liabilitiesmake up the basic components of the money supply at the different Mi(M1, M2, M3, etc.) levels. A rapid growth pattern of Mileads to fears it might be followed by inflation.
There is practically no limit to the amount the banking system can expand the money supply, said Marriner Eccles, chairman of the Fed in the Franklin Roosevelt years. Eccles was against lever- age. His father had taught him that “A business, like an individual, could remain free only if it kept out of debt.”4
All this is relevant to our discussion because money supply underpins Paul Samuelson’s two classes: transaction liquidity and general market liquidity. The notions presented in the preceding paragraphs also serve to bring attention to the fact that Dr. Samuelson’s classification of the demand for money—transactions and liquidity proper—gives altogether a very simplified picture. Shifts in demand for money can be most rapid and unpredictable, therefore altering the overall pattern— and globalization further promotes pattern changes.
The simplification and idealization of a real-world situation is meaningful only when we know what we are after and appreciate the approximations we make. Financial analysts should map eco- nomic and financial relations into models only afterthey really understand the critical factors influ- encing the market and its behavior. Subsequently, what mathematics can describe computers can bring to life through experimentation.
LIQUIDITY RISK, VOLATILITY, AND FINANCIAL STATISTICS
Many knowledgeable financial analysts have suggested that even if the books do not say so, liq- uidity risk is the biggest exposure a financial institution can take because it impacts on the institu- tion’s reserves and on its liabilities in the short, medium, and longer term. Drexel failed because it could not roll its commercial paper. Therefore, a Treasury functions properly when it understands the liabilities structure of the firm and associates it to projected liquidity. This structure can be mod- eled, and it should be kept under perspective with every new commitment and with every examina- tion of current obligations
Liquidity must be measured both in qualitative and quantitative terms—not in a quantitative way alone. Dr. Henry Kaufman says that liquidity has to do with the feel of the market. Reference has been already made to the fact that liquidity is no real problem when the market goes up. It becomes a challenge when:
• The banking system gets destabilized, as in Japan from 1990 until today.
• Market psychology turns negative with the prices of stocks and the other commodities going south.
The regulation of liquidity is so much an art because ways and means we have available are essentially imperfect. This has been demonstrated by the brief discussion on money supply metrics.
Contrary to what mightseem to be the case, overleveraging is an enemy of liquidity—and it could make the survival of some big banks problematic, as in the case of huge loans to telecommunica- tions companies discussed in Chapter 1.
Timely and effective liquidity management, therefore, should be a steady preoccupation of cred- it institutions. After all, they have huge liabilities made up of financial assets of households, busi- nesses, and governments—and, usually, their own capital is only a small percentage of their total footings, as Kaufman aptly suggests.
Sometimes interest on liquidity management takes a back seat because of an ill-conceived wealth effect. Its importance depends on absolute value and composition of wealth, on the impact of mon- etary policy, and on changes in consumption and investment decisions. Changes in financial struc- ture toward greater recourse to securities markets are likely to reinforce the importance of wealth effect, as households and nonfinancial corporations probably will hold a larger share of their wealth in the form of financial market instruments such as corporate bonds and/or equity. However, this mechanism can be weakened by the fact that:
• Credit institutions also hold in their portfolio debt securities, shares, and other equity issued by nonfinancial entities.
• The control of exposure of the private sector to price fluctuations in such instruments is not keeping pace with developments in these markets.
This is another reason that making an institution’s financial staying power is so important. Tier-1 banks establish liquidity limits based on two levels of reference: (1) liquidity risk, by risk type, risk factor, currency, and market; and (2) liquidity volume, by open position and individual security in their portfolio or in which they are interested for future investments. What do regulators look for when they examine a financial institution’s ability to survive? Four questions are topmost:
1. Does it have risk limits of a type appropriate to our business?
2. Do its policies constrain the trading to the risk/reward ratio desired by top management?
3. Does it have real-time monitoring of all transactions? of tick-by-tick exposure?
4. Is top management sensitive to deviations and the breaking of limits?
The component elements underpinning these queries form, so to speak, the infrastructure on which a control model operates. Beyond this, a valid internal control model needs an input from every operating department. It also requires building a modularcapital code to permit flexible risk control, splitting financial exposure according to counterparty, instruments being handled, and their volatility. As far as the control structure is concerned:
• Liquidityandvolatilityare those prevailing in the market.
• Cash flowhas to be carefully calculated by channel of activity.
• Interest-rate riskmust be tractable intraday. (See Chapters 11 and 13.)
The input from regulators must include a great deal of clear definitions and guidelines. For instance, how many degrees of freedom do we have in handling commercial mortgages? Valid approaches will invariably involve taking a look at securitized products and working by analogy:
Can we manage the loan book as ifit were a bond book?
We can develop securitization models that reflect policies and practices with house mortgages
Market Liquidity and the Control of Risk
connection with cash flow estimates (see Chapter 9) as well as with cash holdings. It is wrong to place the cash book into the banking book, a practice followed because of cash management rea- sons. The cash book is part of the trading book.
In the absence of clear regulatory directives, it may be wise to look at what some of the best- managed financial institutions are doing: How do they massage and mine market data, and what do they get out of their models? In short, how do they increase their business acuity in performing in different environments? Said Brandon Davies, of Barclays Bank: “As we get more sophisticated we find we consume time and thought trying to develop solutions other banks do already.”
Theeconomic turnover ratiois a model that can extend what has been discussed about ratios in Chapter 7. It addresses market liquidity by measuring the total value of all trades divided by a coun- try’s market capitalization. A thorough analysis also looks at stock market volatility and the open- ness of a country’s capital market.
Current account information is also important. Based on U.S. Department of Commerce statis- tics, Exhibit 8.2 shows the pattern of physical goods imports over three decades: 1970 to 2000. The exponential growth shown in this figure finds its counterpart in trade deficit connected to physical goods and the U.S. current account deficit. Both are shown in Exhibit 8.3. The careful reader will appreciate the similitude of these two patterns.
It is also wise to examine how closely different indicators are correlated with economic growth.
In principle, countries with the most liquid stock markets tend to grow fastest. Stock market liq- uidity is a convenience, but price changes can distract attention from the need to assess corporate value regularly and to evaluate the way corporate governance behaves.
Exhibit 8.2 Statistics on Three Decades of Imports of Physical Goods in the United States
$ BILLIONS
1970 1980 1990 2000
1,200
0 600 1,000
400
200 800 1,400
Exhibit 8.2 Statistics on Three Decades of Imports of Physical Goods in the United States
$ BILLIONS
1970 1980 1990 2000
1,200
0 600 1,000
400
200 800 1,400
Mathematical models and simulation provide a great deal of assistance in studying current account deficits and the analysis of factors characteristic of corporate governance. Investing in equi- ties demands the ability to analyze an entity’s intrinsic value (see Chapter 9) and ignore emotion when stocks become volatile. The best strategy is to follow a company, its products, and its instru- ments closely and make a long-term commitment. Only when fundamentals change is it wise to sell;
but it is worth monitoring prices all of the time.
Even stop-loss systems considered to be a rather conservative approach are geared toward port- folios, not the typical investor. Sell limits can be useful for locking in gains but also may prompt premature selling of equities that have considerable volatility, such as technology stocks.
With all these constraints in mind, one may ask the question: Why does market liquidity matter that much? For one thing, investors avoid illiquid markets and illiquid instruments. Also, liquid equity markets allow investors to sell shares easily while permitting firms access to long-term cap- ital through equity issues. Many profitable investments require a long-term commitment of capital.
MARKING TO MARKET AND MARKING TO MODEL
Liquidity risk and price risk due to volatility are part of market risk. Both are fundamental elements in the business of every financial intermediary. The liquidity risk faced by a credit institution may be its own or that of its major client(s) in some country and in some currency. Clients who are unable to meet their financial commitments are credit risks, but they also create liquidity problems.
Price risk affects earnings. It may arise from changes in interest rates, currency rates, equity and commodity prices, and in their implied volatilities. These exposures develop in the normal course of a financial intermediary’s business. Therefore, an efficient risk control process must include the establishment of appropriate market controls, policies, and procedures permitting a rigorous risk Exhibit 8.3 Deficit from Trade of Physical Goods and Current Account Deficit of the U.S.
Economy