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How does liquidity affect the financial market? The truth you absolutely want to know!
In macroeconomics and financial markets, liquidity is a key indicator of whether assets can be quickly converted into cash. However, liquidity crisis is an acute phenomenon in financial markets, often accompanied by a sharp drop in asset prices, causing or aggravating the overall economic recession. This article will delve into how liquidity affects financial markets and reveal the underlying truth behind liquidity crises.
Definition of Liquidity Gap
Liquidity can be defined from multiple perspectives, including market liquidity, funding liquidity and accounting liquidity. Market liquidity refers to the ease with which assets can be converted into cash; funding liquidity involves the ability of borrowers to obtain external funds, while accounting liquidity is a criterion for assessing the health of a financial institution's balance sheet.
Liquidity gaps typically reflect a decline in asset prices, potentially pushing them below their long-term fundamentals.
A historical review of liquidity crises
In 1983, economists Diamond and Dybvig proposed a model of liquidity crises and bank runs that highlighted how banks are at risk of liquidity crises by accepting assets that are inherently illiquid. Such contracts can easily cause depositors to have a "self-fulfilling" panic due to their lack of confidence in the bank's future.
Even 'healthy' banks can fail due to depositor panics, ultimately leading to a liquidity crunch in the overall economy.
Strengthening Mechanism
In the event of a small negative shock to the economy, the two self-reinforcing mechanisms of liquidity crises are the balance sheet mechanism and the lending channel. Specifically, falling asset prices erode the capital of financial institutions, forcing them to sell assets during periods of low prices, further pushing asset prices lower.
In this case, borrowers are forced to engage in "fire sales", which not only reduces asset prices but also worsens external financing conditions.
The relationship between asset prices and liquidity crises
When a liquidity crisis occurs, asset prices usually fall significantly. Research shows that when investors take on liquidity risk, they naturally demand higher expected returns as compensation. Therefore, the liquidity-adjusted capital asset pricing model (CAPM) states that the higher the liquidity risk of an asset, the higher the required return.
Policy role
In a liquidity crisis, the role of government policies cannot be underestimated. Policies can alleviate market liquidity crises by absorbing less liquid assets and replacing them with government-guaranteed liquid assets. These policies can cover both ex ante and ex post intervention in a targeted manner. Providing insurance against losses to asset holders or establishing deposit insurance would help reduce panic about people withdrawing their money.
If policies can pre-emptively strengthen the capital structure of financial institutions, this can make them more resilient in the face of economic shocks.
Liquidity crisis in emerging markets
For emerging markets, financial liberalization and the inflow of short-term foreign capital may exacerbate banks' liquidity crisis. Especially in the context of capital outflows, emerging markets are often more susceptible to the withdrawal of external funds, which makes them particularly vulnerable.
Conclusion
The liquidity crisis highlights the fragility of the financial system in the face of internal and external pressures, prompting us to think about how to enhance market liquidity and further protect the economy. When liquidity is insufficient, can we find sustainable and effective responses to maintain economic stability and health?
