Ten Propositions about Liquidity Crises
A liquidity crisis is defined as a sudden and prolonged evaporation of both market and funding liquidity, with potentially serious consequences for the stability of the financial system and the real economy. Market liquidity is defined as the ability to trade an asset or financial instrument at short notice with little impact on its price; funding liquidity, more loosely, as the ability to raise cash (or cash equivalents) either via the sale of an asset or by borrowing.
BIS paper (abstract):
What are liquidity crises? And what can be done to address them? This short paper brings together some personal reflections on this issue, largely based on previous work. In the process, it questions a number of commonly held beliefs that have become part of the conventional wisdom. The paper is organised around ten propositions that cover the following issues: the distinction between idiosyncratic and systematic elements of liquidity crises; the growing reliance on funding liquidity in a market-based financial system; the role of payment and settlement systems; the need to improve liquidity buffers; the desirability of putting in place (variable) speed limits in the financial system; the proper role of (retail) deposit insurance schemes; the double-edged sword nature of liquidity provision by central banks; the often misunderstood role of “monetary base” injections in addressing liquidity disruptions; the need to develop principles for the provision of central bank liquidity; and the need to reconsider the preventive role of monetary (interest rate) policy.
Ten propositions about liquidity crises by Claudio Borio