Market Liquidity and Funding Liquidity

Abstract

We provide a model that links a security's market liquidity -i.e., the ease of trading it -and traders' funding liquidity -i.e., their availability of funds. Traders provide market liquidity and their ability to do so depends on their funding, that is, their capital and the margins charged by their financiers. In times of crisis, reductions in market liquidity and funding liquidity are mutually reinforcing, leading to a liquidity spiral. The model explains the empirically documented features that market liquidity (i) can suddenly dry up (i.e. is fragile), (ii) has commonality across securities, (iii) is related to volatility, (iv) experiences "flight to liquidity" events, and (v) comoves with the market. Finally, the model shows how the Fed can improve current market liquidity by committing to improve funding in a potential future crisis.

Understanding Bank-Run Contagion

“…4,5 1 Allen et al (2011, chapter 3) identify five sources for systemic risk: common exposure to asset price bubbles; mispricing of assets; fiscal deficits and sovereign default; currency mismatches in the banking system; maturity mismatches and liquidity provision. A growing literature examines a wide range of channels through which contagion in the banking sector may occur, such as common asset exposure (Acharya, 2009;Ibragimov et al, 2011;Wagner, 2010), domino effects through the payments system or interbank markets due to counterparty risk (Allen and Gale, 2000;Dasgupta, 2004;Freixas and Parigi, 1998;Freixas et al, 2000;Rochet and Tirole, 1996), or price declines and resulting margin requirements (Brunnermeier and Pedersen, 2009). Beyond these recent events, the contagion of deposit withdrawals across banks has been documented for the U.S. during the Great Depression (Calomiris and Mason, 1997;Saunders and Wilson, 1996) as well as more recently in emerging markets (De Graeve and Karas, 2010;Iyer and Puri, 2012). However, the existing literature provides only scarce guidance on which underlying economic and informational conditions may foster contagious bank runs.…”

Assessing Performance of Liquidity Adjusted Value-at-Risk Models

“…Said differently, the model implies that investors should worry about a security's performance and tradability both in market downturns and when liquidity "dries up". Brunnermeier and Pedersen (2009) provide a model that links an asset's market liquidity and trader's funding liquidity. The model explains empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to "flight to quality" and (v) co-moves with the market.…”

Leverage and preemptive selling of financial institutions

“…It may be determined by regulatory restrictions or by private contracts in the financial sector (as in Brunnermeier and Pedersen (2009) For expositional simplicity, we assume the margin constraint binds or does not bind depending on the time 1 price of the risky asset. We discuss alternative timing assumptions regarding margin calls in Section 5.2.…”

“…8 If this margin requirement tightens during a financial crisis (e.g., if it is set by counterparties), then it is this lower M that is the proper input into our model. Indeed, in Brunnermeier and Pedersen (2009), the margin constraints can tighten exactly when traders need liquidity the most. This can create an adverse liquidity spiral.…”

“…M it is not simply a parameter set by the Federal Reserve, but probably endogenous to a crisis, too. (Brunnermeier and Pedersen (2009) There are at least two more remarkable comparative statics:…”