Stability in financial institutions and in financial markets are closely intertwined. Banks and other financial institutions need liquid markets through which to conduct risk management. And markets need the back-up liquidity lines provided by financial institutions. Market liquidity depends not only on objective, exogenous factors, but also on endogenous market dynamics. Central banks responsible for systemic stability need to consider how far their traditional responsibility for the health of the banking system needs to be adapted to promote stability in the relevant financial markets.

Crockett, A.

English

Research Papers in Economics

Banque de France ￿ Financial Stability Review – Special issue on liquidity ￿ No. 11 ￿ February 2008  13
Market liquidity and ﬁ  nancial stability
ANDREW CROCKETT
President
JPMorgan Chase International
Stability in ﬁ  nancial institutions and in ﬁ  nancial markets are closely intertwined. Banks and other ﬁ  nancial 
institutions need liquid markets through which to conduct risk management. And markets need the back-up 
liquidity lines provided by ﬁ  nancial institutions. Market liquidity depends not only on objective, exogenous 
factors, but also on endogenous market dynamics. Central banks responsible for systemic stability need 
to consider how far their traditional responsibility for the health of the banking system needs to be adapted 
to promote stability in the relevant ﬁ  nancial markets.
NB: The views expressed in this paper are in the author’s personal capacity.ARTICLES
Andrew Crockett: “Market liquidity and ﬁ  nancial stability”
14  Banque de France ￿ Financial Stability Review – Special issue on liquidity ￿ No. 11 ￿ February 2008
T
he second half of 2007 has provided an object 
lesson of the role of liquidity in ﬁ  nancial 
stability. Problems in the subprime mortgage 
sector of the US have led to a drying up of liquidity 
in a range of markets, many of which are not directly 
related to the mortgage sector. In turn, the loss of 
liquidity has caused falls in asset values which 
has led to distress at certain ﬁ  nancial institutions, 
and caused turmoil in credit markets. Banking 
institutions in the United Kingdom and Germany, 
far from the origin of the crisis, have had to be 
rescued. At the time of writing (November 2007), 
it is unclear whether these developments will have 
major negative effects on real economic activity, but 
the potential is clearly there.
This erosion of liquidity recalls earlier episodes, most 
recently in 1998 and 2003, when markets “seized up” 
as a result of generalized unwillingness to enter into 
transactions. These should not be regarded as simple 
aberrations. They reﬂ  ect characteristics of market 
liquidity that have been insufﬁ  ciently appreciated 
until now. These include:
￿ Liquidity is not dependent simply on objective, 
exogenous factors, but is crucially inﬂ  uenced by 
endogenous forces, especially the dynamic reactions 
of market participants in the face of uncertainty and 
changes in asset values.
￿ As a result of the foregoing, liquidity can be subject 
to a “dual equilibrium” phenomenon. In favorable 
conditions, liquidity is easily available and “cheap”. 
But under stress conditions, liquidity becomes very 
scarce and expensive. It may become effectively 
unavailable.
￿ Liquidity in markets and for individual intermediaries 
is much more interdependent than often realized. 
Markets are dependent on back-up liquidity lines from 
ﬁ  nancial institutions, and institutions are dependent 
on continuous market liquidity to execute their risk 
management strategies.
￿  The actions of individual market players to 
conserve liquidity, while individually fully rational, 
can collectively have the effect of reducing liquidity 
in the market place as a whole.
In the remainder of this paper, I will examine the 
basis of these propositions, and analyse the dynamics 
of market stress. I will close with some reﬂ  ections 
on policy implications and the way in which central 
banks manage markets.
1| W HAT IS LIQUIDITY?
Liquidity is easier to recognize than to deﬁ  ne. 
At root, liquidity is the ease with which value can 
be realized from assets. Value may be realized either 
by using creditworthiness to obtain external funding; 
or by the sale of owned assets in the marketplace. 
The former concept, “funding liquidity” is relevant 
for the ability of ﬁ  nancial institutions to perform 
their intermediation functions. Typically, a ﬁ  nancial 
institution is a supplier of liquidity, issuing liquid 
liabilities in order to hold less liquid assets, using its 
capital to cover liquidity risk and making a turn on 
the provision of liquidity services that justiﬁ  es the 
cost of the capital involved.
The second concept, “market liquidity”, refers to the 
ability to undertake transactions in such a way as to 
adjust portfolios and risk proﬁ  les without disturbing 
underlying prices. The dimensions of market 
liquidity include:
￿ market “depth”, or the ability to execute large 
transactions without inﬂ  uencing prices unduly;
￿  “tightness”, or the gap between bid and offer 
prices;
￿ “immediacy” or the speed with which transactions 
can be executed;
￿ and “resilience”, or the speed with which underlying 
prices are restored after a disturbance.
It is worth noting that the distinction between 
funding liquidity and market liquidity is becoming 
less relevant. Financial institutions now manage their 
liabilities and assets in a holistic way. They do not 
simply approach the market to fund a given portfolio 
of assets. Rather, they confront changing market ARTICLES
Andrew Crockett: “Market liquidity and ﬁ  nancial stability”
Banque de France ￿ Financial Stability Review – Special issue on liquidity ￿ No. 11 ￿ February 2008  15
conditions using risk management techniques that 
involve a combination of asset sales, liability issuance 
and derivative transactions, aimed at achieving the 
optimum risk proﬁ  le, given their assessment of the 
risks and returns from alternative portfolios.
2| T HE DETERMINANTS 
  OF MARKET LIQUIDITY
It used to be believed that market liquidity could be 
analysed in terms of objective exogenous factors. 
A market was thought likely to be liquid if:
￿ market infrastructures were efﬁ  cient, leading to low 
transactions costs and thus narrow bid-ask spreads;
￿ there were a large number of buyers and sellers, 
implying that order imbalances could be quickly 
adjusted by small movements in prices;
￿  and the assets transacted had transparent 
characteristics, so that changes in perceptions 
of underlying value would be quickly translated 
into prices.
While these factors remain important, they only 
help to deﬁ  ne the relative liquidity of different 
markets in normal times. In times of stress, the 
dynamic outcome of behavioral responses by 
individual market players takes on considerable 
importance. Since market participants generally 
acquire assets and liabilities to trade, they will be 
particularly concerned about the conditions under 
which they can on-sell assets, or can use them as 
collateral for funding needs. They are, in other 
words, concerned not only about fundamental 
long-term value, but also about the value they can 
realize in circumstances under which they need to 
liquidate a position quickly.
This consideration implies a circularity in the concept 
of liquidity. An asset that is perceived as liquid 
will be demanded for its liquidity characteristics. 
But one that is perceived as lacking in liquidity 
will lose demand. What is of particular interest 
is how a category of assets can move from being 
regarded as liquid, (and therefore demanded both for 
intrinsic characteristics and for liquidity services) 
to being regarded as illiquid. The experience of the 
second half of 2007 provides some clues.
Asset-backed commercial paper was regarded as 
among the most liquid of instruments. So liquid, in 
fact, that the issuing banks charged very little for the 
liquidity enhancement features they offered, and 
did not regard the contingent liability they faced as 
requiring much, if any set-aside capital. The liquidity 
originated in the fact that the borrowing entities 
were highly creditworthy, and the valuation of the 
underlying collateral was regarded as well-founded 
(using ratings provided by rating agencies).
When it became clear that certain types of paper 
were worth less than their face value, and that the 
discount was hard to estimate, there was a move 
to reduce exposures. It is important to realize that 
the move to reduce exposures was due both to the 
intrinsic loss in value of the underlying assets as 
well as to the loss of liquidity services from paper 
the demand for which had dried up. It was, to put 
it in other words, a combination of a repricing of 
risk and a “lemons” problem. A lemons problem 
arises when the potential purchaser of an asset 
has imperfect knowledge of its characteristics, and 
hence is unwilling to offer as much as the lowest 
price the seller is prepared to accept. In the case of 
asset-backed securities, the realization that collateral 
was (or might be) impaired, and that the degree 
of impairment was unknown, caused a collective 
unwillingness to trade. Further, the fact that such 
assets had become, in practice, unsaleable, meant 
that they lacked any liquidity characteristics, which 
further reduced their value.
3| T HE DYNAMICS OF LIQUIDITY 
  AND MARKET DISTRESS
Liquidity is a concept that can usefully be considered 
in light of the observed “procyclicality” of the 
ﬁ  nancial system. Procyclicality refers not simply to 
the well-known psychological phenomenon which 
leads to an interaction of greed and fear among 
ﬁ  nancial market participants, but to certain objective 
features of risk management practices that lead to 
alternating cycles of exuberance and retrenchment 
in the ﬁ  nancial sector.ARTICLES
Andrew Crockett: “Market liquidity and ﬁ  nancial stability”
16  Banque de France ￿ Financial Stability Review – Special issue on liquidity ￿ No. 11 ￿ February 2008
As an economic upswing proceeds, asset values 
increase, causing collateral values to rise, and inducing 
additional lending by ﬁ  nancial institutions. Those that 
have ﬁ  nanced positions through leverage proﬁ  t most 
during this upswing. These gains provide borrowers 
with the incentive and the means to borrow more, 
and provide lenders with the comfort that their risks, 
(calculated with reference to experience over recent 
years) are acceptable. During this upswing phase of 
the cycle, therefore, leverage tends to increase, and 
lending institutions take on what, with the beneﬁ  t of 
hindsight, can be seen as more risky exposures. The 
system at large becomes more vulnerable to a change 
in the cycle, although this vulnerability is obscured 
by apparently strong balance sheets.
In this phase, it is difﬁ  cult for an institution that 
wishes to adopt a more conservative stance to do 
so. Credit costs seem to be low, liquidity is cheap 
and easily available, volatility is moderate, and 
competitor institutions are aggressively pursuing 
market opportunities. Those who stand aside face a 
loss of market share, perhaps lasting for a protracted 
period, before they can be proved right. In the words 
of Charles Prince, if the music is playing, they more 
or less have to dance.
But the situation is not sustainable. Eventually, a 
trigger signals a change in the economic cycle. The 
trigger may be wholly external, possibly caused 
by geo-political concerns, or a sudden increase in 
commodity prices; it may be policy-induced, for 
example, a preemptive rise in interest rates by the 
central bank, or it may be endogenous, such as 
overlending to a particular sector, eg housing.
Whatever the cause, however, it is the dynamic 
reactions that do the most damage. As individual 
institutions or market players see declines in asset 
prices, they see their capital cushions shrink and 
seek to protect their liquidity by reducing exposures. 
Declining prices have the further effect of raising 
perceived volatility and “value-at-risk”. Once again, 
the reaction of an individual institution is to reduce 
exposures to limit risk. Not relevant to the actions of 
the individual institution is the market consequences 
of its actions in raising risk and reducing market 
values for the generality of other market players.
4| P OLICY OPTIONS
Central banks and banking regulators have 
traditionally seen their responsibility as covering 
the banking institutions that are at the core of the 
ﬁ   nancial system. In this, they have developed 
practices to try and prevent problems from emerging, 
as well as to manage or resolve problems that 
nevertheless occur.
On the preventative side, the principal tools have 
been to prescribe minimum ratios of capital and 
liquidity that are sufﬁ   cient to maintain public 
conﬁ  dence in banking institutions even in times 
of stress. The problem with this approach is that 
the reactions of banks to an erosion of their capital 
or liquidity position can accentuate the market 
pressures that gave rise to the problem in the ﬁ  rst 
place. If a bank is attempting to maintain a capital 
ratio of x percent, and something happens to cause 
the ratio to fall below the target, the natural response 
is to sell assets to restore the desired ratio. This in 
turn pushes down asset prices and exacerbates the 
liquidity pressures faced by other banks.
In the longer term, it would seem desirable to use 
supervisory tools to ensure that banks maintain 
sufﬁ  cient capital and liquidity in normal times, 
such that an erosion of ratios can be allowed 
to occur in times of stress, without requiring a 
response. For example, through the use of stress 
tests, supervisors could require banks to build up 
capital even in circumstances in which conventional 
measures of risk showed low vulnerability. Then, 
when the cycle turned, and measures such as 
value-at-risk were rising, supervisory guidance 
could allow accumulated capital and liquidity to be 
prudently used without banks having to run down 
balance sheets precipitately or liquidate assets in 
unfavourable market conditions.
This would represent an attempt to offset the natural 
procyclicality of the ﬁ   nancial system. Whether 
it would be fully effective is another question, 
however. It has to be recognized that attempts by 
ﬁ  nancial institutions to reduce lending to maintain 
capital ratios are not simply driven by regulatory ARTICLES
Andrew Crockett: “Market liquidity and ﬁ  nancial stability”
Banque de France ￿ Financial Stability Review – Special issue on liquidity ￿ No. 11 ￿ February 2008  17
requirements but just as powerfully by market 
expectations. There is a natural reluctance to reveal 
declining ratios in times of market stress, however 
good the justiﬁ  cation.
Turning to how to manage stress at ﬁ  nancial 
institutions once it has emerged, central banks have 
well-established practices governing how to respond to 
purely liquidity pressures. These include a willingness 
to lend, at a penalty rate and on good collateral, to 
banking institutions that face funding liquidity (but 
not solvency) problems. The locus classicus for this 
approach is Bagehot’s “Lombard Street”.
These principles have stood the test of time, and 
central bankers would rightly be very reluctant 
to challenge them. However, in modern ﬁ  nancial 
systems, they leave a number of problems for 
which there are no very easy answers. One is the 
well-known issue of how to distinguish between 
liquidity and solvency pressure. As I have argued 
earlier, loss of liquidity leads to loss of value, and this 
can cause a liquidity problem to become a solvency 
problem. Moreover, not only can banks become 
illiquid before they become insolvent, they can also 
become insolvent before they become illiquid.
A second issue is how to provide liquidity support 
to ﬁ   nancial institutions in circumstances where 
such support is fully transparent to other market 
participants. Nowadays, transparency has become 
the norm for the conduct of public policy. In practice, 
however, transparent provision of ﬁ  nancial support will 
often be interpreted as a conﬁ  rmation of vulnerability, 
leading to the very reactions by depositors and 
counterparties that the support is designed to prevent. 
Central banks and governments need to reﬂ  ect on 
whether transparency, in itself a desirable feature of 
public policy, can in some circumstances undermine 
the objectives it is intended to serve.
A third issue is how to respond, if at all, to illiquidity 
in markets rather than at ﬁ  nancial institutions. The 
traditional answer has been to say that markets can 
take care of themselves. Markets clear, at least in 
theory, and there should be a price at which willing 
buyers and willing sellers come together. There is, 
again in theory, no economic harm if prices move 
to balance supply and demand.
This view neglects certain crucial facts, however. 
First, markets can seize up and fail to perform their 
function of matching buyers and sellers. In the 
process, the loss of liquidity impairs the ability of 
ﬁ  nancial institutions such as banks to use markets 
(and particularly derivative instruments) to manage 
their risk. Modern risk management relies on 
continuous liquidity in short term markets for the 
dynamic hedging of risk.
A further problem is presented by the fact that 
valuation of the assets and liabilities held by banks 
is increasingly based on mark-to-market accounting.   
When markets are illiquid, asset valuations can 
change rapidly, leading to volatility in the key ratios 
used to judge banks’ strength. So central banks 
concerned with preserving the stability of ﬁ  nancial 
institutions have, willy-nilly, a strong interest in the 
preservation of market liquidity.
Central banks have focused on maintaining liquidity 
at the short end of the money market. They have 
generally been willing to step in and provide the 
liquidity needed to keep overnight interbank rates 
near their policy target. In the recent market 
turmoil, there was some debate about how to view 
such assistance. Some saw it as providing support 
to a market (and indirectly to institutions) that had 
become overextended, and therefore that should be 
provided only at a penalty rate. An alternative view 
is that liquefying a market that has encountered 
liquidity difﬁ  culties is an extension of monetary 
policy actions aimed at keeping policy rates close 
to the target.
An issue facing central banks as they attempt to learn 
lessons from the recent turbulence is going to be if 
and how to extend liquidity assistance to markets. 
Should the range of collateral be broadened? And 
should the duration of assistance be extended? 
My view of the answer to these questions is in 
the afﬁ  rmative, though I recognize this goes into 
controversial and uncharted territory. Markets have 
become larger relative to ﬁ  nancial institutions in the 
intermediation process; and their role in effective risk 
management has grown. Central banks will, I believe, 
have to recognize that their overall responsibility for 
systemic stability makes it harder for them to take a 
hands-off attitude to market liquidity.

Market liquidity and financial stability.

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Market liquidity and financial stability.

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