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Mr. Hobbs is an independent consultant and former commercial bank treasurer. The authors would like to thank William E. Alexander and V. Sundararajan for initiating the research project and providing valuable comments. This draft has also benefited from comments by staff of the Central Bank of Argentina and the Central Bank of Mexico, and by Edward Frydl, Eliot Kalter, Meral Karasulu, Elisabeth Milne, Gabriel Sensenbrenner, Mark Swinburne, Bob Traa, and other colleagues during an MAE seminar. Research assistance was provided by Jahanara Begum and Anil Bhatia.
In response to the crisis in Asia, finance ministers and central bank governors from 22 systemically important countries prepared a report on strengthening national financial systems, emphasizing the modalities for liquidity and coining the term “systemic liquidity”, which is adopted in this paper. (Report of the Working Group, 1998)
The volatility of bank creditors will also be influenced by the unique experiences of creditors. For example, creditors who have experienced bank runs or state confiscation of deposits may be more sensitive to perceived risk than those whose experience is limited to a more stable environment.
The exchange rate regime and its credibility play influence the liquidity properties of foreign exchange deposits. In some highly dollarized economies foreign currency deposits may be more stable than local currency deposits.
Many analysts view such assets as liquid if the volatility of their associated liabilities are properly captured (as liquid) in overall measures of liquidity. Balance sheet data do not necessarily distinguish between assets that are pledged and those that are not.
However, yields on liquid (government) securities may be higher than a reasonable return on investments; and under such circumstances, it may be highly profitable for banks to hold liquid assets.
Another standard indicator is a loan-to-deposit ratio which shows the extent to which a bank has committed its stable funds to clients in the form of loans. When loan commitments are low relative to the banks’ stable source of funds, liquidity may be described as ample and vice versa. See, for example Basel Committee (1993). Other measures of funding volatility include direct empirical estimation of the volatility of liabilities, or analysis of interest spreads to derive a liquidity risk premia.
For example, in many countries, a mortgage loan would be considered an illiquid asset. However, if there is a well-developed secondary market for mortgage loans, a mortgage loan may be a liquid asset since it can easily be sold for cash.
Depth is as important as in thin markets deviations of market prices from their underlying equilibrium values may be caused by the size of the trader.
Information in this regard can either be public (available to all market participants, such as publicly announced statistics) or private (not available to all market participants, but only to dealers).
Integration has to be seen in the context of concentration of market liquidity. Notwithstanding the availability of many assets of different maturities and product design, market liquidity is usually concentrated in relatively few assets.
Claessens et.al (1999) and La Porta et.al. (1997). Most of the literature on creditor rights refers to nonbank enterprises. Nevertheless, the criteria used to assess creditor rights are relevant for banking. These are the timetables (number of days) for reaching judgement, the rights of management during resolution, high priority for secured creditors, and automatic stay for assets. Similarly, criteria for court efficiency (costs, duration, etc.) have been established.
Given the importance of international finance, it is essential that there is no discrimination against foreign creditors.
The maturity profile of a bank’s liability often understates actual liquidity as deposits are normally not demanded at the end of term. See Fed New York (1990).
If the liability to which reserve requirements apply is measured periodically (as opposed to being averaged), banks would have an incentive to avoid the tax on the day of measurement. This could lead to transaction maturities of a length only within the measurement period. On the day of measurement, volumes traded could fall and the price of interbank trades could rise, leading to spikes in interbank rates around the period of measurement.
The same effect could be achieved but with increased payments risk by extending the settlement period to next-day settlement, for example.
The design of monetary instruments can also affect foreign exchange liquidity. For example, a requirement to hold required reserves on foreign currency deposits in foreign, continued rather than domestic, currency will provide a greater liquidity cushion against large deposit withdrawals in foreign exchange. Such a requirement will also eliminate the demand for additional liquidity to meet reserve requirements in the event of a depreciation of the domestic currency.
In this regard a notable exception is the Federal Reserve Board’s description of facilities under its discount window.
Even where the modalities of safety nets are not explicitly defined ex-ante, they can support confidence in the market. This can be beneficial in facilitating excess reserve recycling outside the central bank. Nonetheless, significant moral hazards can be inherent, if these arrangements are badly designed. Good banks (or depositors) could lose the incentive to monitor troubled banks and price their credit risk appropriately.
The countries are: Argentina, Brazil, Canada, Germany, France, India, Indonesia, Japan, Korea, Malaysia, Mexico, Thailand, United Kingdom, and United States.
Systemic liquidity crises were experienced in: Indonesia, Japan, Korea, Mexico, and Thailand.
For example, the impact of margin calls cannot be fully appreciated from the above balance sheet presentation.
On December 29, 1995, CNBV issued Circular No. 1284 requiring that banks revise their accounting practices to conform more closely to IAS, beginning in 1997.
Karaoglan and Lubrano (1995).
The central bank had the authority and the willingness to act as a lender of last resort, as did the government-owned development banks, which had the ability to rediscount bank loans.
Fourth quarter foreign exchange losses for the system as a whole were equal to 10 percent of total equity. See Karaoglan and Lubrano (1995).