Sun Sep 4th, 2011 at 01:12:09 PM EST
Liquidity has almost been given a bad name by all of the officials who have claimed that the problem with the economy from 2008 to today is lack of liquidity. Critics have vociferously asserted that the bigger problem is solvency. Given the price history of US residential real estate since 2008 and the size of the class of US RMBS financial assets from 2002 to 2006 the solvency of institutions holding these RMBSs certainly seems questionable. But looked as on its own merits, as opposed to the camouflage uses to which it has been put, liquidity is an important and neglected factor in our financial markets.
London Banker has a new post on this subject: Liquidity, Liquidity, Bank Capital and Market Reform. After all, there was a time when central banks were not the chief source of liquidity and it would seem desirable to find a way to return to that situation, especially seeing that re-inflating the bubble doesn't seem to be working so well. His post consists of a series of comments from a friend's e-mail, shown here in orange, to which London Banker responds.
Central bankers and securities regulators lost sight of liquidity over the past decade or two in permitting reforms which compromised the health of the financial system. Thanks to the Greenspan and Bernanke puts, and to surplus recycling by Asian economies, many took liquidity - like oxygen - for granted. Like oxygen, you only realise how critical liquidity is when its absence becomes noticeable.
Now that bank regulators have rediscovered liquidity as an essential attribute of healthy banks and healthy markets, it is important to reinforce some key qualities.
Liquidity means you can generate cash from a physical asset or paper claim.
If you can't exchange the asset for a major currency to meet a sudden funding need, then the asset shouldn't be permitted as regulatory capital. Basel II and Basel III have generated hundreds of pages around credit scoring and asset type while ignoring the fact that most of what banks are attributing as capital cannot be turned into cash on demand.
But, effectively, the criteria came to be having a AAA rating on the asset. But that was like Kansas before the tornado of 2008. The tornado exposed the fraud of the AAA ratings and "We ain't in Kansas anymore!"
Liquidity can be gained by sale or repo of an asset, preferably in a transparent market. Where no market exists or the market has become illiquid, then liquidity must be gained through a central bank.
Virtually all RMBS markets failed under stress in 2008 and 2009, with failures spreading to other asset classes as investors grew wary of dealer spreads and perceived shallow dealer commitment levels. As the scope of funding problems grew, illiquidity spread to sovereign debt for troubled countries such as Greece and Portugal. Few OTC asset markets have recovered sufficient liquidity for dealing in size.
When the public markets will not price an asset in size without a large spread, then the central banks become the market makers of last resort. Without central bank repo of illiquid RMBS and sovereign debt, virtually every major bank in the OECD would have failed.
Because they now have the role of market maker of last resort, central banks should become much more active in ensuring that any asset permitted to be classed as capital by a bank can be liquidated on demand in a public market. Rather than leaving market structure to the investment banks and their tame securities regulators, the central banks should be driving forward reforms to ensure that capital assets are issued in fungible series, in size, and traded in transparent exchange markets with committed market makers.
This will require a major policy reversal on exchange regulation. Securities regulators have been under pressure for several decades to liberalise OTC markets, permit fragmentation to off-exchange trading systems, and turn a blind eye to issuance of securities in small, idiosyncratic offerings that will never liquidly trade except back through the offering investment banks. The quality assurance and market conduct functions of exchanges have been eroded following demutualisation, and exchanges now are run for profit of their highly concentrated owners rather than in the public interest.
Markets are at the heart of successful civilisations. Markets require quality norms, information publication, and price transparency to operate effectively. Regulators and investors allowed credit ratings to substitute for exchange listing rules and reporting requirements during the liquidity boom. Ratings were gamed by the banks until they were meaningless. We should now be forcing assets back onto exchanges and force the exchanges to regulate quality and information norms in the public interest. If this requires re-mutualising the exchanges, or public ownership of exchanges, then that should be on the agenda. Letting the exchanges be run by the thugs who gamed the markets and the rating agencies isn't healthy.
"Regulatory forbearance" via "extend and pretend" and refusal to prosecute fraud on the pretext that it would further damage the markets are not healthy either. But regardless of the implausibility of an appropriate governmental response to this situation it is still useful to have a clear set of requirements for properly functioning financial markets.