Understanding liquidity

by George Hatjoullis

The word liquidity pops up all the time in finance and economics. People use it casually as if it has a unique meaning. It does not. The most liquid asset is cash in your pocket. You can go into a shop and spend it. Cash in the bank is not so liquid. You can make a same day payment via faster payments, in the UK, but subject to some restrictions. You can also use the less restricted BACS system for a charge. So even with cash, liquidity evidently has time and cost dimensions.

Liquidity involves converting an asset into cash. Even an ‘unsecured loan’ is such a conversion. The ‘unsecured loan’ is of course never unsecured. It is secured on the borrowers future income. Liquidity is measurable in terms of how long it takes to arrange the loan and what it costs. Similarly, if one borrows against a tangible asset it is about time and price. When central banks talk of increasing liquidity they are referring to this kind of liquidity in relation to banks. Liquidity seems to be a characteristic of assets and banks and central banks.

One can also convert assets to cash through change of ownership (or sale). On the face of it this involves the same two dimensions; time and price. One has shares in a company and one can sell them quickly though the price is uncertain. From an individual point of view this is all there is to it. Liquidity of assets however is a function of the liquidity of markets if liquidity involves sale. This means something a little different.

In a pure broker market, buyers are matched with sellers. The liquidity of the asset may vary a great deal depending on buyers at any point in time. A third dimension is added which is ‘uncertainty’. There is obviously uncertainty about price but, less obviously, about whether one can sell at all. No buyers need turn up. This led to the function of the ‘market maker’ emerging. An entity would commit capital and promise to make a two-way market at all times. The market making function reduces uncertainty about whether there will be a buyer. Such secondary markets are thus more liquid. Note liquidity is achieved by committing capital to the secondary market.

The secondary market may also break down (market failure has been discussed at length in many previous blog posts) so the uncertainty is not completely eliminated. The more capital that is committed, the greater the liquidity. So liquidity in terms of sale is not simply a characteristic of assets or banks or banking systems. It is also a characteristic of markets.

The regulatory aftermath of the 2008 financial crash has seen the market making function dramatically degraded. It only properly exists now for products listed on exchanges and not always then. Markets are less liquid. The central banks have tried to offset this by liquifying an increasingly wide range of assets. If you have a bond that is on a QE programme then it is liquid. If you have an asset you that can borrow against it may be liquid. However, it may not be as liquid as it once was.

Banks must hold capital against loans and the capital requirement is in part a function of the quality of the collateral. Capital requirements have been tightened considerably. It does not matter how easily a bank can borrow from the CB, its lending is a function of capital. The amount of capital allocated to bank lending is a function of profitability and banking is not so profitable at the moment. Bank capital is thus not too plentiful. So bank provided liquidity and market liquidity have both diminished and only central bank provided liquidity has expanded. Central bank provided liquidity can never offset the loss of the bank and market liquidity. The amounts are simply too large.

Central banks have been struggling to offset the loss of liquidity after 2008 and this was a direct consequence of the regulatory response. It is an impossible task. The financial system has a lot of assets but surprisingly little liquidity (properly understood) and this is a policy preference. The question arises what will happen if the system is shocked and liquidity is required. Those imagining that central banks can and will act are deluding themselves, including many central bankers.