The Liquidity 411

Sun, 16 Nov 2008 15:02:04 +0000

Your Sunday required reading this week comes from Professor Lasse Heje Pederson of NYU, courtesy of VoxEU, "Understanding Liquidity Risk and the Current Crisis." Jumping straight to the conclusions:

If the problem is a liquidity spiral, we must improve the funding liquidity of the main players in the market, namely the banks. Hence, banks must be recapitalised by raising new capital, diluting old equity, possibly reducing face value of old debt. This can be done with quick resolution bankruptcy for institutions with systemic risk, i.e. those causing liquidity spirals.

Further, we must improve funding markets and trust by broadening bank guarantees, opening the Fed's discount window broadly (giving collateralised funding with reasonable margins), and ensuring the Commercial Paper market function. Further, risk management must acknowledge systemic risk due to liquidity spirals and the regulations must consider the system as a whole, as opposed to each institution in isolation.

If we have learned one thing from the current crisis, it is that trading through organised exchanges with centralised clearing is better than trading over-the-counter derivatives because trading derivatives increases co-dependence, complexity, counterparty risk, and reduces transparency.

Read the whole thing.