Personal Finance and Money Management

The word liquidity can refer to a number of different concepts dependent upon the words immediately preceding in which it is placed. Perhaps it’s most familiar usage is that in which it describes the ease with which an asset can be bought or sold, be the asset in question a real one (e.g. a house) or a financial one (e.g. a bond). This usage also extends to the effect which such a purchase or sale has upon the price of an asset, i.e. the more liquor an asset, the lesser the effect of trading activity upon its fundamentals. This is known as ‘asset’ liquidity.

Another different frame of reference for the word liquidity is where one is considering the ease with which credit can be accessed in the various financial markets. For instance, a highly liquid market (from a pecuniary point of view) would be described as one in which solvent firms and individuals are able to access leverage quickly and easily from a range of sources. This manifestation is known as ‘funding’ liquidity.

Whilst both types of fluidity outlined above are quite separate in their own rights, ‘asset’ and ‘funding’ liquidity can of course be said to be related, largely given the incestuous and interconnected nature of national and indeed global financial markets. Therefore, whilst one might describe the effects of various factors upon each respective form of liquidity, it can be argued that they’re moved by similar if not – in some cases – identical forces, either directly or indirectly.

Imagine a simple example where a positive economic climate has emerged – funds become more readily take advantage of, individuals lay siege to more funds in firms, asset prices increase, firms gain more finance, firms increase production, households buy more products, etc. One can easily see how ‘asset’ liquidity and ‘funding’ liquidity are inherently related and can to some extent create vicious circles of economic boom and bust, should market participants not be steadfast to theories of efficient markets, etc.

Thornton (2009) comments however that “[n]o absolute measure of the liquidity of the financial markets exists”.

Financial markets exist ultimately to channel credit from lenders to borrowers. Within these markets, institutions provide centralisation to the provision of this credit, taking advantage of economies of scale, and nurturing maturity transformation. This allows lenders to lend ’short’ and borrowers to borrow ‘long’ – a feat which would be deemed impossible should lender and borrower need to deal one to one individually in the absence of such an intermediary to manage a pool of clients.

‘Funding’ liquidity is essential to the proper operation of such financial markets in an efficient and effective manner. Lenders must be able to invest surplus funds, and retrieve on demand, whilst borrowers fustiness be able to access leverage where required. Confidence in the ability of financial markets to fulfil such duties is key.

The ability of firms and individuals to gain access to funds can have profound effects upon the economy, in the same proportion that was touched upon briefly overhead. Where funds become smaller liquid, e.g. it’s else difficult to gain finance than it was six months ago, firms and individuals will ultimately spend less, and lower consumption will lead to unemployment. Such a situation be possible to easily spiral out of control unless there is intervention to reduce the negative effects.

An inability to gain funds naturally suggests an imbalance, a disproportionate relationship between the level of supply and the level of demand. Where this is the case, it’s highly likely to result in further adverse effects. For example, short term interest rates will rise due to the lack of funds available (and indeed long term rates if the pure expectations theory of the term structure of interest rates is to be believed). Firms and individuals will vanish even less and a country’s GDP will suffer.

Geithner (2007) stated that ” … like confidence, liquidity plays a critical role both in establishing the conditions that can guidance to a financial shock, and in determining whether that shock becomes acute, threatening broader damage to the functioning of financial and credit markets”.

The monetary authorities clearly have a part to play whither imbalances arise. In the UK, we have a ‘tripartite’ system, where the Bank of England is central bank, the Financial Services Authority is regulator, and HM Treasury is governmental policy maker. Given their respective mandates, it is therefore in the interests of each of these bodies to elevate a stable financial system. Note that their independence is of importance given the potential conflicts of interest that could arise – whilst they share common objectives, each institution has its own defined responsibilities requiring potentially contradictory courses of action.

The Bank of England’s primary responsibilities include implementation of monetary policy (via its Monetary Policy Committee), banker – and lender of last resort – to commercial deposit taking institutions, and banker to the government. In its implementation of monetary policy, the Monetary Policy Committee decides the official base rate that it perceives will honour its commitment to HM Treasury’s inflationary target (currently 0.5% and 2% respectively). In its role as banker to banks, construction societies, and government, the Bank holds deposits for these institutions and acts as a source of funds where required for the mercantile intermediaries.

Importantly, the Bank has an overarching obligation to the maintenance of a stable financial system in the UK, one which has been recently reemphasised with the introduction of the Banking Act 2009. Therefore, ‘funding’ liquidity is of interest to the Bank, and there’s a recognition that its actions on the back of the responsibilities described above can affect such liquidity, particularly given its position as monopoly supplier of reserves.

The financial system of the UK is based upon fractional reserve banking, whereby deposit taking institutions including banks and building societies do not retain 100% of demand deposits, opting tolerably to lend a (significant) percentage to ‘deficit units’, i.e. borrowers. This approach instigates an expansion of the financial system’s money supply which is at once welcomed and derided by different observers and commentators.

The fractional reserve system suggests that our deposit taking institutions do in fact have significant control covering the liquidity of funds within the system, and whilst this is to some extent true, the central bank – as stated above – actually retains a monopoly in the truest sense, of the all important base currency reserves.

Not only is the financial system of the UK based upon fractional reserve banking, but furthermore, no ‘mandatory reserve ratio’ is imposed by the tripartite authorities. This indicates a system of ‘prudential’ standards, by the agency of which deposit taking institutions are free to decide the level of reserves that they hold – a fine balance between the hunger for profits, and the highly important need to retain consumer confidence. (The very nature of fractional reserve banking implies that potential ‘bank runs’ are immensely dangerous given the effectively tiny average ratio of demand deposits held by deposit taking institutions.)

Again, whilst it might be considered that banks and building societies have a powerful grasp over liquidity, one important point to note is that where such an intermediary attempts to increase its loan book by persuading clients from another institution to transfer their deposits, this will only serve to reduce reserves of the latter, who is likely to echo this move by enticing the former’s clients to transfer.

Where a widespread shortage of ‘funding’ liquidity exists in an economy, the central bank is the only (lender of last resort) source for further base funds, even despite the existence of the parallel markets which centralise exchange of instruments such as Certificates of Deposit. Whilst such securities are an ideal source of interbank liquidity transference, they’re no use if banks and building societies do not have said liquidity to transfer. The Bank of England controls both price and quantity of reserves in the UK and utilises a number of vehicles to this end.

First, the Bank operates standing facilities through which intermediaries can borrow or deposit funds. Second, the Bank allows intermediaries to borrow high quality government bonds through its discount window. Third, the Bank buys and sells high trait government bonds through its evident market operations. Finally, the Bank oversees a process of reserves averaging whereby deposit taking institutions are remunerated or reprimanded for falling inside or outside of reserves targets respectively.

The Monetary Policy Committee’s base rate decisions underpin the mechanisms with which the Bank of England undertakes the provision of liquidity to the UK fiscal system. Therein lies the power of the central bank to set the price at which such liquidity can be accessed – and therefore to influence the level of subsequent demand.

‘Funding’ liquidity has become one of the hot topics of debate and a noticeably crucial aspect of the financial system during the recent ‘meltdown’.

Further to a loss of confidence in leverage which was backed by volatile underlying assets, and the realisation by many that a number of financial intermediaries in the UK were exposed to such ‘toxic assets’, a general nausea and nervousness enveloped the domestic pecuniary system (and indeed those of farther afield).

Adrian and Shin (2009) commented that “[t]he language of ‘liquidity’ suggests a stock of available funding in the financial system which is redistributed as needed. However, when liquidity dries up, it disappears altogether rather than being re-allocated elsewhere”.

Lack of confidence in the ability of Northern Rock to fulfil its obligations and to carry on as a going concern led to a ‘run’ on the intermediary. This adventure, along undoubtedly with countless other factors including an element of ‘noise’, triggered financial firms to raise their shields, refusing to have commerce with counterparties in many markets, and in so doing crippling the level of liquidity generally. As discussed earlier, such a situation foliage only the central bank as a source of funds to allow continuing day to epoch operations.

The tripartite authorities realised (eventually, more would argue) that the exigency was one impacting all financial firms to at least some extent, and acknowledged a lack of liquidity primarily due to firms being unwilling to deal in asset and mortgage backed securities – triple A rated or not! The Bank of England subsequently announced its ‘Special Liquidity Scheme’, a temporary arrangement instigated primarily to provide ‘funding’ liquidity to the financial system given the inherent distaste in spite of asset and mortgage backed securities.

The Bank of England (2008) declared that “[t]he situation will improve only if the overhang of illiquid assets on banks’ balance sheets is dealt through. Only then will banks be willing to lend to each other and, importantly, to the wider economy”.

Different from existing measures, for instance open market operations where firms pledge high quality government bonds considered in the state of collateral, intermediaries are able to swap less desirable securities for a marked down basket of government securities. These securities are in theory extremely highly regarded – although the Debt Management Office’s most recent Gilt auction result suggests some make horizontal of doubt from the market! Foreign authorities have launched similar schemes to ease their respective liquidity crises, e.g. the Federal Reserve’s ‘Troubled Assets Relief Programme’.

This discussion has highlighted the importance of ‘funding’ liquidity in the respect of its contact on financial systems and the real economy. Whilst liquidity causes less sleepless nights in salutary financial systems, it’s clear that the role of the central bank becomes most appreciated (and observed) where markets are not functioning as they should.

However, it’s important to consider whether responsibility according to such liquidity lies wholly at the door of the authorities. Other stakeholders of the financial system must understand that their actions have real effects and indeed ask themselves whether they have a part to play in encouraging wholesome, liquid markets.

Jenkinson (2008) subscribes to this conclusion, saw that ” … it is clear that primary responsibility for bolstering the defences lies with the banks themselves and that supervisory regimes for liquidity risk need reinforcing to support that process.”

Manchester Metropolitan University coursework assignment by Martin Corrigan – March 2009

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Tags: Influencing Liquidity, Liquidity