The Looming Liquidity Crisis
Summary: the changing nature of the financing of the economy, where more and more actors are in charge of and dependent on collateral intermediation, has transformed the nature of financial risk. Meanwhile, the absorption capacity of many dealers and market-makers has declined as a result of the post-crisis rise in the regulatory burden. Coupled with a growing exposure of investors to illiquid assets, this trend is, to us, the harbinger of the next financial crisis. The last crisis was mostly linked to securitization and funding liquidity. The next one could be triggered by a failure in market liquidity (ability of assets to shift swiftly across the system).
It might sound as a paradox to warn against a liquidity crisis at a time when central banks across the board are pouring huge amounts of liquidity to fight, among other things, deflation. The aggregate amount of assets held by central banks globally has reached a historical high of 20 trillion U.S. dollar, roughly 25% of global GDP. Yet, recent developments in the financial markets suggest that illiquidity could be the harbinger of difficult times ahead.
From One Model to the Other
Liquidity has for long been at the core of economic crisis models, but it was mostly about the liquidity of physical capital. The most famous of them was developed in 1983 by Diamond and Dibvig. It explores the risks associated with the transformation of maturities, that is in using short term liquid deposits to finance long term non-liquid investments (housing, Capex…). Credit restrictions (crunch) would be accentuated whenever there would be stress on the liability (deposit runs) or on the asset side - the quality of assets would be impaired by default risk and influenced by the cyclical position of the economy. Banks have for long been seen as intermediaries able to manage this risk as well as to mitigate the asymmetry of information between lender and borrowers. That was at the core of the traditional “originate to hold” model of banking. In this framework, the concept of liquidity pertained to the intrinsic feature of the physical asset that has to be financed and the ability of depositors to have access to their funds in short notice.
In the old/traditional framework, banks are thus seen as conducting a qualitative transformation of assets: liquidity creation and transformation of risk. This financing of illiquid assets with liquid liability also encompasses off balance sheets loans commitments. In spite of the associated moral hazard, the stability of the model has long been guaranteed by the public guarantee of deposits but it comes at a cost: assets with relatively safe cash-flows and regulations are the other side of a lender of last resort (public bailout has not been formally stated; it was rather implicit and linked to the associated systematic risk of too big to fail institutions).
From originate-to-hold, the model has switched to originate-to-distribute, which has thrived on securitization. Coupled with secured funding, it defines how the so-called ‘shadow banking’ channels saving to investment. In the words of Claessens et al., traditional banks engage in credit intermediation between ultimate savers and borrowers. Modern banks engage, as dealer banks, in collateral intermediation: financing bond portfolios with insured money markets instruments. They are not alone since the list of “shadow institutions” is wide: investment banks, brokerage houses, MMMFs, asset back conduits, SIV, hedge funds... Yet, the distinction between traditional and shadow banking is more artificial and theoretical than empirical since the type of funding and lending involved is common to the entire financial system.
The frontier between ‘real’ banking and ‘shadow’ banking is far from precise: secured funding (of bank and, especially, nonbank investors), securities lending, and hedging (including OTC derivatives) are all parts of the collateral intermediation. “Collateral helps deal with counterpart risks and more generally greases financial intermediation. A small number of dealer banks, all ‘systemically important financial institutions’, that is, banks whose failure could trigger a global financial crisis, are uniquely placed in their ability to facilitate collateral-based operations.” Hanson et al. describe the situation clearly: “when shadow banks—including broker-dealers and hedge funds—create money-like claims such as repurchase agreements, they rely less on the government safety net, and hence can economize on costly equity capital. However, manufacturing safety instead means that shadow banks have to hold assets that can be easily liquidated at the first sign of trouble by investors who must remain vigilant.” Collateral, its quality, liquidity, and the ease with which it is transferred from one to the other is the key factor. If liquidation is not as easy as stated above, troubles more than double, especially in the case of a fire-sale. This is clearly what Pozsar puts forward when he writes, speaking of a financial ecosystem, that “running a maturity mismatch (that is, being in the maturity transformation business) involves rollover risks, and in case of a panic, survival depends on one’s stock of overnight money assets (that is, liquidity) and access to emergency funding, which is not the same for all — this is the hierarchy of liquidity puts.”
On Liquidity and Liquidity Premium
In the context of widespread quantitative easing policies coupled with deflationary threats and compressions in term premia, the sharp decline in long term yield has triggered a “search for yield” that has led many investors to ramp up their exposure to illiquid assets. The aim being to reap the yield pickup provided by the “liquidity premium”, i.e. the compensation received for holding an asset that is not liquid. According to Ang (NBER 19436), “agents would be willing to pay an illiquidity risk premium of 2% to insure against illiquidity crises occurring once every ten years”.
By exposing themselves to illiquid assets, investors receive an illiquidity premium that can compensate for the low yields of safe assets. Yet, in doing so, their ability to rebalance easily, in a timely and costless manner, their portfolio, is considerably reduced since the position is locked either for lack of counterparty or because trade is open during specific time windows. Since there is no continuity in trading opportunities, the difficulty to trade or find counterparty is at the core of the illiquidity risk, whatever the underlying quality of the asset. Another dimension of illiquidity should not be underestimated: the asymmetry of information pertaining to the quality of the asset. The inability to observe the price or quality of the asset is part of the illiquidity issue. Trade frictions (search for a counterparty) and asymmetry of information are the crux of the problem here. The taxonomy of the source of illiquidity can be a guide: participation cost (expertise, valuation of complex structures and type of investors) ; transaction costs (due diligence, commissions); search frictions in finding a buyer; asymmetric information (main source of liquidity freeze); price impact and funding constraints (leverage…).
Interestingly parts of the sources of the illiquidity of assets are linked to the two main characteristics of market liquidity. There are two different concepts of liquidity in financial markets. The funding liquidity is the ease with which a financial intermediary (or investors, custodians) will get funding (amount, maturity) in accordance with its needs. The market liquidity is the ease with which an asset can be sold without incurring a significant haircut (measured by the width of the bid/ask spread in an organized market). It is part of the idiosyncratic feature of a safe asset, to which of course one should add the very low risk of default. Illiquidity can be impaired by access to funding but also by the lack of willingness or power for intermediaries to trade, warehouse and shift assets.
Dual Forces and growing Risks
The fragility of traditional banks that create liquidity through deposit and hold non-marketable loans has partly been offset by the existence of a lender of last resort and public deposit guarantee. A growing part of the financial sectors (investment banks and the rest of the shadow banking industry) is financed through repo funding with marketable securities whose liquidity is not always guaranteed (fire sales, illiquid assets). In addition, liquidity funding needs are done through money-like claims (money market shares, Repos) that cannot be used directly for transaction purposes and thus have to be liquidated for transaction purposes (redemptions).
The compression of yields has led to a search for yield with many consequences. On top of being more exposed to duration risk (rolling down the curve towards longer maturities) or credit risk (high yield for instance), more and more investors are exposed to illiquid assets (in order to reap the illiquidity premium). It is true that illiquidity is dependent on the state of the market (crisis vs. euphoria) as market conditions play a major role. But it has also an idiosyncratic feature: the rise in the proportion of illiquid assets (infrastructures, institutional real estate even illiquid corporate bonds) in investors’ portfolio should be a cause for concern.
The last crisis was mostly linked to securitization and funding liquidity. The next one should be triggered by a failure in market liquidity (ability of asset to shift swiftly across the system).
Looking for Triggers
1. Regulation (ELIE): in a world where dealers are a key component of risk transfer and secured lending, the limit of trading activity (LCR, limits on trading activities and burdensome reporting requirements for market-making) have significantly reduced the inventories of dealers for many asset classes. If the ROI for market marking is reduced by regulation, there is a key risk for the next fire-sale episode.
2. Banks, and more generally, if we include the so-called shadow banking, the financial system, is much more characterized by risk / collateral intermediation
This makes the liquidity of some asset classes contingent on the external environment (withdrawal of market makers when volatility rises) but also on some idiosyncratic factors that can impact them. There are many examples over the last few years:
The looming liquidity crisis has to do with the illiquid feature of many physical and financial assets. Yet it is much less related to any default risk and the associated loss-absorption buffer (capital) that is available than with the losses associated with the lack of “tradability” of the assets involved. The outcome might be the same since huge losses might wipe out capital. But the origin of the crisis would not be linked to an initial default but rather to a drying up of liquidity.
The longer sovereign yields remain low and the longer the scarcity of safe assets (something very likely given that there is no sign of reduction of the size of the balance sheets of many central banks and, meanwhile, fiscal imbalances are being corrected – see chart below), the most likely is a rise in the percentage of illiquid assets in the portfolios of many investors.