When the financial system teetered on the brink of collapse in 2008, the biggest problem was a lack of liquidity. Banks were unable to refinance themselves in the short-term debt markets. Central banks had to step in on a massive scale to offer support. Calm was eventually restored, but not without enormous economic damage.
But has the underlying problem of liquidity gone away? A research note from Michael Howell of Crossborder Capital argues that, in the modern financial system, central banks are no longer the only, or even the main, providers of liquidity. Instead, the system looks a lot like that of the Victorian era, with banks dependent on the wholesale markets for funding. Back then, the trade bill was the key asset for bank financing; now it is the mysteriously named “repo” market.
A repurchase, or repo, agreement involves a borrower selling a bunch of securities for cash and agreeing to buy them back later for a higher price. The difference between the two prices represents the interest payment. The market is huge: a survey by the International Capital Market Association estimated that, in June this year, European repo agreements were worth €5.6 trillion ($6.4 trillion).
To borrow in the repo market, banks need assets to pledge against the loans — collateral, in other words. And, Howell argues, it is the supply of, and demand for, collateral that determines liquidity in the financial markets.
The problem is that not all collateral is treated equally. Lenders worry that, if the borrower fails to repay, the securities they are left holding may not sell for their face value. So they apply a discount, or “haircut,” to the collateral, depending on its perceived riskiness. At times of stress, lenders get nervous and apply bigger discounts than before. This is what happened during the financial crisis (see table, above).
Bigger haircuts mean that borrowers need more collateral than before in order to fund themselves. “When market volatility jumps, funding capacity drops in tandem and often substantially,” writes Howell. The result, a liquidity squeeze at the worst possible moment, is a template of how the next crisis may occur (although regulators are trying to reduce banks’ reliance on short-term funding).
Viewed in this light, global liquidity should not be measured merely by the size of central banks’ balance-sheets but by the availability of acceptable collateral as well. On Howell’s calculations, global collateral shot up in the aftermath of the financial crisis, but grew much more slowly from 2012 onwards. This may explain why global growth has been so sluggish. Read more on CFO.