Market Distress and Vanishing Liquidity: Anatomy and Policy Options

35 Pages Posted: 20 Sep 2007

See all articles by Claudio E. V. Borio

Claudio E. V. Borio

Bank for International Settlements (BIS) - Research and Policy Analysis

Date Written: 2004

Abstract

Since the 1980s, a number of episodes of financial market distress have underscored the importance of the smooth functioning of markets for the stability of the financial system. At the heart of these episodes was a sudden and drastic reduction in market liquidity, characterised by disorderly adjustments in asset prices, a sharp increase in the costs of executing transactions and, in the most acute cases, a "seizing up" of markets. This essay explores the anatomy of market distress as well as the policy options to address it. It argues that, despite appearances, the genesis and dynamics of market distress resemble quite closely those of banking distress and that, contrary to conventional wisdom, the growth of markets for tradable instruments, and hence the greater scope to sell assets and raise cash, need not have reduced the likelihood of funding (liquidity) crises. At times of distress, in contrast to more normal times, risk management practices, funding constraints and counterparty risk become critical determinants of market liquidity. Articulating an appropriate policy response calls for an approach that takes full account of the interdependencies between the behaviour of market participants and market dynamics. To date, much useful work has been done to address market distress by improving the market infrastructure and the risk management at individual financial institutions. The territory that remains largely unexplored is precisely the link between the collective actions of individual market participants and market dynamics.

Suggested Citation

Borio, Claudio E.V., Market Distress and Vanishing Liquidity: Anatomy and Policy Options (2004). BIS Working Paper No. 158, Available at SSRN: https://ssrn.com/abstract=781228 or http://dx.doi.org/10.2139/ssrn.781228

Claudio E.V. Borio (Contact Author)

Bank for International Settlements (BIS) - Research and Policy Analysis ( email )

CH-4002 Basel, Basel-Stadt
Switzerland

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