"With no measure, is liquidity half-full or half-empty?
By Tony Jackson
Published: May 10 2009 17:23 | Last updated: May 10 2009 17:23
One of the more intractable problems to have emerged from the financial crisis is that of liquidity. In normal times, we assume an asset can be sold at its market price. Take that away, and the effects are literally incalculable.
How regulators and practitioners address that is plainly crucial. The trouble is that liquidity is hard to define and can be impossible to measure. There is even disagreement over how far it is a good thing.
For our purposes, liquidity can be taken as the extent to which a security can be traded, promptly and in size, without disturbing the price. Whether that is measurable depends on the type of security in question.
The liquidity of an equity can usually be measured pretty accurately, since the size and price of deals are displayed in real time on the stock exchange screen. Prices of corporate bonds, on the other hand, are mostly not displayed even daily. As for volume, figures are only available months in arrears.
If that is true of basic bonds, it is true in spades of those structured securities which – under the title of toxic assets – lie at the heart of the crisis. So far, there seems little prospect of changing that.
As one simple indicator, take the fact that whereas investment banks have devised hedges against all sorts of other risks, from inflation to longevity, they have yet to come up with a liquidity hedge. That would be a very profitable product. But it would require a common definition and measurement of liquidity itself.
Ditto for the ratings agencies, which have been roundly abused for assessing securities only for default risk and thus, by implication, looking at the wrong thing. But I am assured that they spent a lot of time and effort in the 1990s trying to devise a liquidity measure, only to give it up as a bad job.
It might be thought that regulators, in tackling the liquidity question, would have come up with definitions of their own. Apparently not.
The UK’s Financial Services Authority said last December that it would require banks to give “far more information” on liquidity risk. They should detail their holdings by asset class, maturity, currency, whether they were eligible for central bank monetary operations, and “any other characteristics considered relevant”.
But how is liquidity to be defined? None of our business, the FSA says. The liquidity of individual instruments tends to be “situation-specific”.
Given which, it is striking that the FSA’s list of criteria bears scant resemblance to those applied by UK bond traders themselves, as set out in a pilot study from two former practitioners, David Clark and Chris Golden.
The maturity of an issue, for instance, was placed 32nd by traders in a list of 47 liquidity criteria. Right at the top came whether the bond could be borrowed in the market, and whether it could be easily hedged through derivatives.
It is therefore striking that authorities in general are so exercised about the evils of shorting and credit derivatives, both of which are regarded as essential to liquidity by practitioners. But this brings us to the next point: whether liquidity is seen as desirable at all.
Keynes wrote in 1936 that the “fetish of liquidity” was profoundly anti-social. Individuals could be liquid, but not communities, which were collectively stuck with the underlying asset – the steel mill, shipyard or whatever.
The existence of a liquid market, he conceded, might lower the cost of capital. But it meant the purpose of investment became merely “to pass the bad half-crown to the other fellow”.
Something of the same distaste seems to be emerging today. Lord Turner, chairman of the FSA and author of the authoritative Turner Review on the world banking crisis, remarks in it that tightening liquidity is justified “in order to reduce risks to future financial stability”.
This is in spite of the fact that, like Keynes, he accepts the usefulness of liquidity. For the banks, he says, regulatory restraints on liquidity also mean constraints on “aggregate system-wide maturity transformation” – in effect, the supply of credit. But the price is worth paying.
It might seem we are talking here of a different kind of liquidity – the quantity of liquid assets held in reserve by the banks. The link, though, lies in the definition of what constitutes liquidity in an asset.
If the banks can only hold Treasuries rather than private securities, the less the demand for the latter. The less the scope, too, for securitisation – the vital form of lending which has yet to recover in this crisis, in spite of the best efforts of the authorities.
There are no easy answers to all that – just a lot of questions which seem not so much unanswered as unaddressed. If you wonder why the crisis is dragging on, this is part of the reason.