Liquidity
What is it?
Put crudely, liquidity is used to mean the amount of cash that's sloshing around the system, or the ease with which you can access cash. Put less crudely, it's how easily you you can swap an asset - be it a house, a stock in company X, or a mortgage backed security - into cash.
An asset is said to be 'liquid' if it can be easily exchanged for cash. An asset is said to be 'illiquid' if exchanging it for cash is near-on impossible.
What's it got to do with the financial crisis?
The first symptom of the credit crunch was that mortgage backed securities (MBS) that had previously been liquid suddenly became illiquid overnight. The first real symptom of this came on 9 August 2007, when BNP Paribas halted withdrawals from several of its funds invested in MBS, on the grounds that no one wanted to buy them and it was therefore impossible to tell how much they were worth.
After that, illiquidity spread through the financial system. Buyers disappeared for any financial product linked to mortgages, particularly complex products like CDOs. And banks became a lot less willing to lend to each other, with the result that LIBOR rates increased rapidly.
At the same time, access to liquidity is a real issue for banks. After Bear Stearns saw $10bn of its liquid assets pulled out of the bank in March 2008 and Northern Rock went under, the realisation hit home that other banks could also suffer a 'liquidity crisis'.
Central banks such as the Federal Reserve and ECB have done their best to pump liquidity back into the banking system by exchanging mortgage backed securities for liquid assets at their discount windows.
The Federal Reserve's efforts to flood the markets with liquidity had its drawbacks, however, including the creation of a "liquidity trap" that has kept banks piling on reserves but doing very little lending. drove the main US interest rate to zero but failed to spur lending, as economist Ronald McKinnon pointed out. Commentators have also argued that the government can better serve the economy by creating an orderly system for shutdowns of failed banks rather than propping them up expensively with taxpayer funds.
Last updated on 7 September 2009.
