Market Liquidity Risk

Abstract

Emphasis in studies of financial instability is traditionally placed on bank failures, or consequences of sharp changes in equity prices.’ This paper suggests that market liquidity crises in debt markets, such as the collapse of liquidity in the ECU bond market in 1992, may be of equal or greater concern, particularly given the increasing use of such securities markets both by banks and end-users. It is suggested that such occurrences are not isolated events but part of a pattern that recurs quite frequently in debt markets — an extreme form of market liquidity risk, similar in some ways to contagious bank runs. In effect, securities are transformed to loans, which may entail severe difficulties for those relying on their liquidity, and which can lead to systemic risk in the financial system more generally. An outline is given of aspects of underlying economic theories of financial instability, which have generally been conceived to describe banking crises, and their relation to securities market structure and dynamics. In the light of these, the ECU crisis is analysed together with four similar patterns, in the FRN market, junk bonds, Swedish commercial paper and the Penn Central crisis in the US commercial paper market. Implications for financial stability and regulatory policy generally are suggested.

The views expressed are those of the author and not necessarily those of the Bank of England, Financial Markets Group at LSE or the European Monetary Institute.