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 me, 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 the modeling of banks, but it was mostly about the liquidity of physical capital. The most famous model was developed in 1983 by Diamond and Dibvig. It explored 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 (influenced by the cyclical position of the economy). This was 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 had to be financed and the ability of depositors to have access to their funds in short notice. Banks had an edge in their ability to manage this risk as well as to mitigate the asymmetry of information between lender and borrowers. The selection of debtors was supposedly better handled in a bank-based rather than in a pure securities-market based economy (screening).
In this old/traditional framework, banks are seen as conducting a qualitative transformation of assets: liquidity creation and transformation of risk. This financing of illiquid assets with liquid liabilities also encompasses off balance sheets loans commitments. In spite of the associated moral hazard, the stability of the model has long been ensured by the public guarantee of deposits with an associated cost cost: holdings of assets with relatively safe cash-flows and regulations, albeit not always stringent, are the other side of the very existence of a lender of last resort (public bailout has never been formally stated but has always been implicit given the associated systematic risks 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, securitization defines how the so-called 'shadow banking' is channeling saving to investment. The distinction between traditional and shadow banking is yet more artificial and theoretical than empirical since the type of funding and lending involved is common to the entire financial system. 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. The list of actors involved is quite long: investment banks, brokerage houses, MMMFs, asset back conduits, SIV, hedge funds...
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.
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". For any given asset, the sources of illiquidity are plenty: 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…).
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 counterpart or because trade is open during specific time windows only. Since there is no continuity in trading opportunities, the difficulty to trade or find counterpart 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 gauge quickly the quality of the asset is part of the illiquidity issue. Trade frictions (search for counterpart) and asymmetry of information are the crux of the problem here.
The growing share of illiquid assets in the portfolios of investors highlights the importance of the two main characteristics of market liquidity. The funding liquidity is the ease with which a financial intermediary (or investors, custodians, SIV) 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). A safe asset generally provides some decent market liquidity in every state of the world, 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 deposits and hold non-marketable loans has partly been offset by the existence of a lender of last resort and public deposit guarantee. Securitization has also helped, but in the wake of the originate-to-distribute model, a growing part of the financial sector (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).
Besides, the compression of yields has led to a search for yield whose consequences are not always accounted for. On top of being more exposed to duration risk (rolling down the curve towards longer maturities) or credit risk (high yield market for instance, where covenant light issuance has soared), 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. All the more since dealer's inventories and ability to trade has declined.
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/Enhancers
1. Regulation: 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 to end up badly.
2. A rise in the default rate of one asset class might also lead some investors to reassess the intrinsic illiquidity risk of their entire portfolio. The rise in default of oil-related small businesses could be a good candidate.
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. Given that the collateral absorption of dealer is dwindling and that repo and MMMFs remain quasi-money claims, the divergence between investors' needs (yield pickup), central bank policy targets (safe asset negative yields) and regulation outcome (asset light and lower security inventories), the next crisis might not be driven by credit and funding scarcity but rather by illiquid assets and collateral freeze.
The "financial accelerator" which accentuates the volatility of economic cycle through the bank- credit channel has often been blamed for the peculiar violence of economic through in bank-based economies (cf. eurozone crisis in the late 2000ies). In the current environment, the financial accelerator would not be credit distribution but rather the weakness or even freeze of collateral circulation. This is why restrictions on security trading, and more generally regulation that lead to fewer securities on the balance sheet, albeit justified in some cases, can also be seen as vector aggravation of financial crisis.
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