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What Have We Learned from the 2007-08 Liquidity Crisis?

A Survey

Journal 34: Cass-Capco Institute Paper Series on Risk

Hamid Mohtadi, Stefan Ruediger

The financial crisis of 2007-2008 was a liquidity crisis. Thus, we must both study the source of the crisis and evaluate the regulatory measures to address it. How was this liquidity crisis, and its associated risk, related to other forms of risk? What was the nature of the vicious cycle that produced the crisis? How did the regulators respond and have continued to respond? What are some quantitative dimensions of liquidity risk measures? We provide a critical survey of the existing literature in an attempt to answer these questions.

The financial crisis that began in late 2007 or early 2008, culminating in the collapse of several large U.S. financial institutions such as Lehman, Washington Mutual, Wachovia, Merrill Lynch, and AIG in 2008, and finally settling down in mid-2009, may have in fact had its roots in institutional failure, market failure, excessive risk taking, etc., as has been argued by numerous pundits and scholars alike. However, much of these discussions have focused on the explanation of what went wrong. As such, the policy implications that arise from these discussions relate quite appropriately to ex-ante circumstances, i.e., to improving the financial and regulatory environment in order to prevent the next crisis. However, expost, one is faced with a different question. That question is this: should the system fail again, what safety tools are in place to limit the scope of the disaster? The emphasis in Basel III proposals on banks building up adequate liquidity can be understood in this ex-post context. Thus referring to the 2007-2008 crisis, the Bank of International Settlements (BIS) writes, “the crisis again drove home the importance of liquidity to the proper functioning of financial markets and the banking sector.

Prior to the crisis, asset markets were buoyant and funding was readily available at low cost. The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time” [BIS (2010)]. This paper is about understanding liquidity and liquidity risk, the first in terms of its ex-post properties in attenuating the impact of a severe financial downturn, and the second, in terms of the interaction between different dimensions of liquidity risk, notably funding and balance sheet liquidity risk among banks and other financial entities on one hand, and market liquidity risk among traders, on the other. Understanding this interconnection by bank managers is as important in being prepared for another financial crisis, as having a large amount of liquidity at hand.

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