Liquidity and Crises

Liquidity and Crises

Liquidity and Crises

Liquidity and Crises

Synopsis

Financial crises have been pervasive for many years. Their frequency in recent decades has been double that of the Bretton Woods Period (1945-1971) and the Gold Standard Era (1880-1993), comparable only to the period during the Great Depression. Nevertheless, the financial crisis that startedin the summer of 2007 came as a great surprise to most people. What initially was seen as difficulties in the U.S. subprime mortgage market, rapidly escalated and spilled over first to financial markets and then to the real economy. The crisis changed the financial landscape worldwide and its fullcosts are yet to be evaluated.One important reason for the global impact of the 2007-2009 financial crisis was massive illiquidity in combination with an extreme exposure of many financial institutions to liquidity needs and market conditions. As a consequence, many financial instruments could not be traded anymore, investorsran on a variety of financial institutions particularly in wholesale markets, financial institutions and industrial firms started to sell assets at fire sale prices to raise cash, and central banks all over the world injected huge amounts of liquidity into financial systems. But what is liquidity and why is it so important for firms and financial institutions to command enough liquidity? This book brings together classic articles and recent contributions to this important field of research. It provides comprehensive coverage of the role of liquidity in financial crisesand is divided into five parts: (i) liquidity and interbank markets; (ii) the public provision of liquidity and regulation; (iii) money, liquidity and asset prices; (iv) contagion effects; (v) financial crises and currency crises.

Excerpt

Franklin Allen, Elena Carletti, Jan Pieter Krahnen, and Marcel Tyrell

Financial crises have occurred for hundreds of years. However, the fact that they often appear without warning is something that most people have apparently forgotten in the recent past. Hence the financial crisis that started in the summer of 2007 came as a surprise to many observers. in particular, it was astonishing to see that a breakdown in just one part of the housing market, i.e. the us subprime mortgage market, did lead to a systemic crisis that escalated and spilled over to financial markets all over the world. Thus, the financial crisis, that began in the us, did not only spread to Europe but became global, even affecting emerging markets and less developed countries that resisted the bad lending practices, did not purchase toxic assets, and did not allow their banks to engage in excessive risk taking through derivatives.

One important reason for the global impact of the 2007 financial crisis is massive illiquidity in combination with an extreme exposure of economically and politically relevant parties to liquidity needs and market conditions. As a consequence, many financial instruments could not be traded anymore, investors ran on a variety of financial institutions particularly in wholesale markets, financial institutions and industrial firms started to sell assets at fire sale prices to raise cash, and central banks all over the world injected huge amounts of liquidity into financial systems.

But what is liquidity and why is it so important for firms and financial institutions to command enough liquidity? This handbook brings together classic articles and recent contributions to this important field of research. in this introduction we will provide an overview of the book and review each section in turn, thereby drawing connections to some of the most recent academic literature on liquidity and crises.

We start in Section 1 with a discussion of liquidity and interbank markets. Section 2 considers the public provision of liquidity and regulation. Money, liquidity and asset prices are covered in Section 3. Section 4 is concerned with contagion effects in financial crises. Section 5 considers financial crises and currency crises. Finally, Section 6 concludes.

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