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21-Aug-08
Financial Innovation Amplifies Systemic Liquidity Shocks
A new Working Paper* from the International Monetary Fund finds that increasing financial integration and innovation can make market and funding liquidity pressures readily turn into issues of insolvency.
The paper, which does not represent the IMF’s official view, says that the mechanisms through which liquidity shocks influence various markets may operate through different channels during normal times than in the midst of an episode of financial stress such as the recent subprime crisis. “During tranquil periods, market illiquidity shocks are typically short-lived, as they create opportunities for traders to profit and, in doing so, provide liquidity and contribute to the price-discovery process. ”
However, during periods of crisis, several mechanisms may amplify and propagate liquidity shocks across financial markets, creating systemic risks.
These mechanisms can operate through direct linkages between the balance sheets of financial institutions, but also indirectly through asset prices, the paper says. Leverage in the models can amplify the financial cycle. “Specifically, asset price movements are set in motion when financial institutions face marked-to-market price declines.”
The paper finds that the interaction between market and funding illiquidity increasedsharply during the recent period of financial turbulence, and that bank solvency became important. In contrast, many of the transmission channels were not present before the onset of the crisis.
*Transmission of Liquidity Shocks: Evidence from the 2007 Subprime Crisis (by Nathaniel Frank, Brenda González-Hermosillo, and Heiko Hesse).
Posted at 12:16 in External Blog | Permalink | Comments () | Top
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