Financial market liquidity and the lender of last resort.

In the summer 2007, difficulties in the US subprime mortgage markets have led to disruptive developments in many financial market segments, in particular in interbank money markets, where central banks in the US and in Europe repeatedly intervened to restore smooth market functioning. This article investigates the circumstances in which liquidity shortages may appear in fi nancial markets and evaluates a number of options available to the lender of last resort wishing to restore fi nancial stability. It also suggests that the consideration of balance sheet data is not sufficient for evaluating the risks of leveraged financial entities. Instead, the analysis calls for an explicit consideration of collateral pledges, market illiquidity, and potential non-availability of market prices. Our main messages can be summarised as follows. First, we provide a clear hierarchy across policy alternatives. Taking a risk-efficiency perspective, it turns out that targeted liquidity assistance is preferable to market-wide non-discriminatory liquidity injections. In particular, when liquidity may be alternatively used for speculative purposes during the crisis, non-discriminating open market operations may attract unfunded market participants that divert funding resources away from its best uses in the financial sector. As a consequence, targeted liquidity assistance may become strictly superior. Second, we suggest that forced asset sales may lead to disruptive market developments in a context where financial investors are highly leveraged. Assuming away external funding or renegociability of debt contracts, a fully leveraged investor hit by a liquidity shock would have to liquidate some assets. When markets are not perfectly liquid, asset liquidation depresses market prices. Under standard risk management constraints, lower prices induce a re-evaluation of marked-to-market balance sheets, provoke margin calls, and trigger further selling. In the worst scenario, the leveraged investor may not be able to face the sum of liquidity outfl ows and subsequent margin calls. In that case, the market for illiquid assets breaks down, rendering the valuation of such assets an ambiguous exercise. For investors, such potential trading disruptions imply that the loss that triggers operational default is likely to be much smaller than suggested by standard risk measures.

Financial Market Liquidity and the Lender of Last Resort.

It has been argued in the literature that emergency liquidity injections should be conducted preferably in the form of open market operations. As we show in the present paper, this is not necessarily the case when liquidity may be alternatively used for speculative purposes during the crisis. In such a situation, non-discriminating operations may attract unfunded market participants that divert funding resources away from its best uses in the financial sector. As a consequence, targeted liquidity assistance may become strictly superior. The analysis might have a bearing on recent developments in the context of the subprime crisis.Liquidity ; Financial markets ; Lender of last resort.

Forced Portfolio Liquidation.

We study the problem of a leveraged investor that is forced to unwind a significant fraction of its portfolio in a collection of illiquid markets. It is shown that markets may become disrupted in response to a relatively small liquidity shock. As a consequence, the probability of default can be much higher than suggested by standard risk measures. We also study the impact of successful liquidation on relative asset prices. Our analysis suggests that effective risk management of leveraged financial entities should focus on the entity's potential to generate emergency cash-flows net of third-party claims for liquidity.Portfolio liquidation ; Market disruption ; Leverage ; Determinants of asset liquidity ; Hedge funds ; Structured credit.

Declining Valuations and Equilibrium Bidding Central Bank Refinancing Operations.

It is argued that bidders in liquidity-providing central bank operations should typically possess declining marginal valuations. Based on this hypothesis, we construct equilibrium in central bank refinancing operations organised as variable rate tenders. In the case of the discriminatory pricing rule, bid shading does not disappear in large populations. The predictions of the model are shown to be consistent with the data for the euro area.Open market operations ; Uniform price auction ; Discriminatory auction ; Eurosystem.