What are we doing to help liquidity?

Clearly, the Fed and other central banks have provided huge amounts of liquidity by adding assets to their balance sheets. These efforts have reduced the economic decline but the issue of liquidity is more complex then flooding reserves. The drinking from a liquidity fire hose does not solve longer-term problems of how markets and banks function. In fact, we still have the problem that banks will not lend. For example, the bank reserve addition does not directly address liquidity issues in the shadow banking system which has exploded through the ABS market.

Barron's had a good article in the December 28th 2009 issue called "A Flat Dow for 10 years? Why it could happen" describing the research work on liquidity by some leading economists. The conclusions now seem obvious; nevertheless, we now have to learn to find policies that will solve liquidity problems. Here are some observations on liquidity that I have gained from reading this literature. This is more than a banking issue since many loan products are now traded as securities.

• Leverage will have a real economic impact. However, what drives institutions to take levered trades is less clear. Lack of regulation may be one part but not the whole story. Think of China where there is a strong state run system that is having a property and leverage boom. Leverage is a function of what abks perceive as the risks. The environment matters and if the government sends signals or behaves in a manner that suggests thatere is limited downside risk, more leverage will be taken on by the market.
• The shadow banking system and securitization is fundamental to the working of credit markets. Lending is not just a banking activity. Hence, regulation between banks and securities has to integrated.
• Just because something is securitized does not mean that it is a liquid security. Similarly, just because something has a triple-A rating does not mean that it is liquid.
• Liquidity spirals are a problem. Whenever there is a capital call in one market, there is the potential for a ripple effect into other markets. The raising of capital in one market will require the selling of more liquid securities.
• The selling of some securities will lead to more selling if there is a price effect. Feedback effects are real. Price pressure even temporary can lead to liquidity crises.
• Liquidity is related to the level of information that players have in the market. Less information means less liquidity.
• Skill effects the liquidity of securities. If the valuation of security requires skill, there will be less liquidity.
• Simple securities will always have more liquidity than complex securities.
• Complex securities will require a liquidity premium independent of its level of specialization. More specialized or customized securities require more liquidity.
• Confidence effects liquidity. If there are loses in a type of security, there will be a loss of confidence which will affect the willingness of investors to re-enter the market. Hence, there will be a loss of liquidity.
• More data and information on securities will increase the level of liquidity. Data is a public good that helps all market participants even though it may hurt profits for a given market maker.
• Liquidity will affect arbitrage opportunities. Arbitrage will not take place without a premium if there is a the perception that there is less liquidity in the market.

Unfortnately, there has not been anything done to improve the liquidity in the markets by regulators. This does not seem to be an area of concern.