Liquidity

Simon Freedman, Bob Tom and Robin Thompson

Liquidity in the financial markets appears to have lowered since the onset of the credit crisis. There are two primary drivers for this. First, higher liquidity, capital, leverage and funding requirements for bank balance sheets, as well as tighter risk limits, have led to a structural decline in banks’ ability to warehouse risk. Second, the central bank response to the crisis has been to reduce interest rates and stabilise markets through quantitative easing programmes involving the purchase of government bonds, reducing risk premiums and trading volumes. In this chapter, we will focus on the regulatory impacts. We first look at the direct banking regulations concerning liquidity, as well as other regulations that indirectly impact market liquidity, including clearing and margin rules. We will examine the state of liquidity in financial markets and the differing views of markets participants vis-à-vis policymakers.

INTRODUCTION

Historians may debate whether news of the death of Knickerbocker Savings Bank triggered the banking panic of 1854, leading to a run on other savings banks in New York. What is not contentious is that a run on a bank is a function of rumour. Once rumour