Liquidity is a critical component of well-functioning financial systems that have become more and more complicated over time. In such systems, large banks and institutions have a key role to play as intermediaries, facilitating trade across a wide range of securities, markets and national borders.

Yet we have witnessed several liquidity crises in the past few decades, in which investors have been unable to trade securities or access capital markets adequately. These include: the 1987 US stock market crash; the Russian default in 1998; the Long Term Capital Management (LTCM) episode in the same year; and, most recently, the period following the credit downgrades of General Motors and Ford in May 2005 (see case study on opposite page).

Why does the liquidity of markets dry up so dramatically and in a manner that is both episodic and pervasive? What are the implications of such liquidity risk for banks and financial institutions? Recent academic work based on a careful look at the crises provides some answers.

The two regimes of capital markets

Liquidity crises tend to be preceded by, or associated with, significant negative shocks to prices of assets such as stocks and bonds.

To understand why, it is useful to think of capital markets as existing under two regimes. In the “normal” regime, financial intermediaries are well-capitalised and liquidity effects are minimal; prices of assets reflect fundamentals and there is no (or little) liquidity effect.

By contrast, in the “illiquidity” regime, intermediaries are close to breaching their capital constraints: an internal value-at-risk constraint; the capital adequacy requirement imposed by regulators; margin requirements imposed by exchanges; or a collateral constraint imposed by lenders.

Prices in the illiquidity regime reflect the cost of capital faced by intermediaries, that is, their “rental” cost from issuing an additional unit of funding in order to facilitate trades in the markets they intermediate.

In other words, in the illiquidity regime, the level of capital of intermediaries in the market for a particular security also affects the price of that security.

Viewing capital markets as consisting of two regimes helps to clarify why the prices of securities co-move excessively at certain times. Practitioners often call this “correlation risk”, whereby the correlation between returns across different markets changes over time and, in particular, increases significantly in certain periods.

Two characteristics of excess co-movement bear a striking similarity to the episodic nature of liquidity risk. First, correlation in prices of primitive securities, such as stocks and bonds, appears to rise in bear markets. Second, correlations in primitive risks implied by traditional models to price derivatives, such as options and synthetic portfolios of bonds and loans, also fluctuate substantially.

The link to liquidity

Our view is that these movements are linked to liquidity. In the normal regime, correlations across asset prices are driven by correlations in fundamentals of the underlying entities or risks. If we think of prices as discounted expected cash flows, then the correlation arises due to common shocks that affect expected cash flows (such as the business cycle) and discount rates (such as the interest rate).

However, in the illiquidity regime, prices are also affected by how costly it is for financial intermediaries to provide capital against the risk of holding illiquid and risky securities. In such times, an intermediary is willing to facilitate trading by holding a given position of securities only if a substantial discount can be charged to the seller. Since this illiquidity discount is related to an intermediary’s capital and the cost of funding it, rather than to fundamentals, it affects the prices of securities traded by these intermediaries across the board.

In turn, this creates a correlation in prices that is over and above the one induced by fundamentals. By implication, fluctuations in the capital adequacy of intermediaries during the illiquidity regime cause fluctuations in measured correlations of asset returns.

Consider the LTCM crisis and the GM and Ford downgrade. In the first case, adverse news about a large country (Russia) and in the second instance, large corporations (GM and Ford), led to a massive round of liquidations, causing securities to sell at “fire sale” discounts, intermediaries to scramble for capital, and inducing excess co-movement across many markets and sectors.

Conclusion

The lack of liquidity in markets and excess co-movement across markets are intimately related, and both arise during periods of significant negative shocks to asset prices. For risk managers and the hedging strategies their organisations employ, these relationships have two key implications. First, modelling extreme illiquidity scenarios using the stress tests employed by banks and financial institutions for assessing risk can be useful, but only if it is recognised that liquidity dries up precisely when there has been a substantial negative shock to prices. Second, even if existing models work well in the normal regime, as tools for hedging derivatives that are exposed to correlation risk, these models are likely to fail in the illiquidity regime.

In the illiquidity regime, hedging fluctuations in liquidity and correlation requires holding liquidity buffers, such as treasuries and highly-rated securities whose prices remain relatively stable (or may even rise) in response to adverse shocks to markets, and access to funding sources, such as lines of credit issued by safer institutions and perhaps the central banks themselves.

Case study: The GM and Ford downgrades

On May 5 2005, Standard & Poor’s downgraded the debts of both GM and Ford to “junk” status. The move was expected, but its precise timing was not and it resulted in significant price movements across several markets and sectors. In particular, the credit-default swaps (CDS) for large banks and credit derivatives, such as collateralised debt obligations, experienced big changes, before reversing – at least in part – within a few weeks.

To understand why, consider the hypothetical example of a CDS contract written on, say, JP Morgan Chase. In return for a fixed annual premium, the holder of such a contract would be insured against any losses resulting from a default by JP Morgan Chase over a specific period of time. Thus, a widening of CDS premiums on JP Morgan Chase would represent an increase in the price of default insurance for JP Morgan Chase.

Why did the downgrade of GM and Ford cause the CDS premium on JP Morgan Chase and other large banks to widen? One explanation is that it caused losses for some hedge funds and there was uncertainty about the size of the exposure of the large banks that were prime brokers to these funds. Another explanation is that, in the period following the downgrade, large banks faced substantial inventory risk.

The total value of GM and Ford securities affected was about $30bn, and many investment vehicles that owned their bonds had to liquidate them to comply with restrictions barring them from investing in junk-rated securities. Also, they had to adjust to the likely removal of GM and Ford from corporate-bond indices. Even high-yield investors often face restrictions on their maximum exposure, so it was difficult for the market to absorb such a large supply of GM and Ford debt.

Financial institutions that intermediate in these markets – large banks and, in particular, their high-yield desks – ended up holding a large chunk of total supply. As a result, several banks faced significantly increased risk from the possibility of a further drop in the price of their junk-rated GM and Ford debt.

Large banks make markets in many securities. The increase in inventory risk combined with the rise in funding costs, forced up the cost of intermediation and produced discounts in prices of securities across the board, including a temporary widening of spreads in the CDS market.

Viral V Acharya is associate professor of finance at London Business School and research affiliate for the Centre of Economic Policy Research.
Stephen Schaefer is professor of finance at London Business School.