The global crisis ruthlessly exposed the weakness of the market for liquidity. This column suggests that banks should issue securities with a “Roll-Over Option Facility” that would allows banks to keep funds if there is turmoil in liquidity markets. It adds that these facilities would help reallocate liquidity risk outside the banking sector, thus reducing the probability and severity of a crisis.
The financial crisis that started in 2007 unveiled the fragility of the market for liquidity and how this was underestimated by market participants and regulators alike. Liquidity risk is particularly deceitful because it carries an externality with potentially large systemic implications. From the individual investor’s perspective, while it may be rational to gain exposure to liquidity risk with a large mismatch in asset-liability maturities, many individual investors do not take into account that, when there is a liquidity crunch, the need to unload assets has adverse effects on others and forces them to sell their positions as well, causing a loss spiral of the kind that exacerbated the recent financial crisis (Brunnermeier 2009).
The problem may become even more acute in the future. The extraordinary measures taken by public authorities to prevent the collapse in the markets for liquidity are likely to amplify moral hazard and reduce banks’ incentives to hedge against liquidity risks. There is a clear need for regulation that addresses the externality created by liquidity risk and reduces the need for public intervention...
Sergio Nicoletti-Altimari and Carmelo Salleo write at VoxEU.org
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Finance Focus
With over 9,000 entries, the Dictionary of Accounting and Finance covers a huge
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as well as more general business and commercial terms. 