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The Secret of Liquidity Crisis: Why Do Asset Prices Fall Sharply?
In financial economics, a liquidity crisis represents an acute state of liquidity shortage. Liquidity can refer to market liquidity (how easy it is to convert assets into cash), funding liquidity (how easy it is for borrowers to obtain external funding), or accounting liquidity (how easy it is for borrowers to obtain external funding). health level). By some economists' definitions, a market is liquid only if it can absorb sudden cash demands from investors. A liquidity shortage may lead to asset prices falling below their long-term fundamental prices, deterioration of external financing conditions, a reduction in the number of market participants, or difficulty in asset trading.
During a liquidity crisis, when market participants need cash, it is difficult to find potential trading partners to sell their assets.
In this situation, asset holders may be forced to sell their assets at prices below long-term fundamentals. At the same time, lenders typically face higher borrowing costs and collateral requirements than in times of abundant liquidity, while unsecured debt is almost unavailable. The functioning of the interbank lending market also tends to be problematic during liquidity crises.
Many different mechanisms amplified the negative impact on the economy through the mutual reinforcement between asset market liquidity and capital liquidity, and eventually evolved into a full-scale financial crisis. This means that even a small negative shock will further aggravate the overall economic contraction caused by the liquidity crisis.
Liquidity Crisis Model
As early as 1983, Diamond and Dybvig proposed one of the most influential models of liquidity crises and bank runs. This model highlights the vulnerability of banks as financial intermediaries, especially when they accept less liquid assets but provide more liquid liabilities. According to this model, banks’ demand deposit contracts play an important role in providing liquidity and risk sharing, but may also pave the way for bank runs.
If market confidence remains, demand deposit contracts can improve outcomes in competitive markets and provide better risk sharing.
But in a panic scenario, all depositors are likely to withdraw their deposits immediately, even though some may actually prefer to keep them. If large-scale withdrawals lead to forced liquidation and sale of assets, this will further aggravate the liquidity crisis and even cause an immediate financial crisis.
Expanding Mechanism
When a small negative shock occurs in the financial market, the decline in asset prices may erode the capital of financial institutions and even affect their book health. This creates a negative feedback mechanism of two liquidity loops that serves to tap into the initial negative shock. Financial institutions are forced to sell assets when asset prices are low in order to maintain their leverage ratios.
Asset prices fall further as investors' net worth erodes, which feeds back into their balance sheets.
In addition, liquidity crises may also be triggered by market participants' uncertainty about market activities. Against the backdrop of continued market innovation, many market participants often rush to participate before fully understanding the risks of new financial assets, which may cause them to flee to more liquid or familiar assets.
The relationship between liquidity crisis and asset prices
During a liquidity crisis, many asset prices fall sharply. Liquidity crises such as the 2007–2008 financial crisis and the 1998 LTCM crisis have led to deviations from the “law of one price,” meaning that nearly identical securities trade at different prices. In this case, due to the sharp reduction in liquidity, investors may be forced to sell assets at lower prices, further exacerbating market instability.
The role of policy
Government policies can play an important role in alleviating liquidity crises. One way to do this is by purchasing illiquid assets and providing liquid government-guaranteed assets instead. Existing policies could be proactive preventive measures, such as setting minimum capital ratio requirements for financial institutions or debt-to-equity ratio caps. This will help improve balance sheet resilience.
In addition, experts suggest that central banks should provide downside insurance during liquidity crises or step in as a lender of last resort. The right intervention can boost asset prices, lower bond yields, and alleviate funding problems in a crisis.
However, these policy interventions also come with costs, so economists warn that the role of lender of last resort should be exercised only in extreme circumstances and should be flexibly decided by the government based on specific circumstances.
Liquidity Crisis in Emerging Markets
Some economists believe that financial liberalization and short-term foreign capital inflows may exacerbate banks' liquidity crisis. In this context, 'international liquidity' refers to the amount by which a country's short-term financial obligations denominated in foreign/hard currency exceed the total amount of foreign/hard currency it can quickly access. In such circumstances, a self-fulfilling panic could easily lead to a greater financial crisis, especially for emerging markets with limited access to global capital markets.
In the new market environment, when investors lose confidence in the market, liquidity will decrease rapidly, which may directly lead to financial and currency crises. In this case, how can the root cause of the liquidity crisis be solved?
