Liquidity is easier to recognise than to define. Which is perhaps why the topic merits a full 190-pages in the Banque de France’s February Financial Stability Review.
We won’t pretend to have read all of it. Instead, let’s home in on the article by Tobias Adrian, from the Federal Bank of New York, and Hyun Song Shin, from Princeton University. How did the deterioration of credit quality in subprime mortgages in the US unspool with such ferocity, causing widespread turbulence across the credit markets? After all, they note, a 1 per cent gain or loss in the US stock market is about the same order of magnitude as the likely subprime losses that will be gradually realised over the next few years.
The key, they suggest, is to follow the reactions of financial institutions to price changes and to shifts in measured risks. Leverage is pro-cyclical, tracking the “waxing and waning of balance sheets in a way that amplifies the financial cycle.”
So why, when balance sheets sharply contracted in 1998 in the aftermath of the LTCM crisis, has there not been a comparable contraction this time round?
The answer lies in the sharp drop in short-term asset-backed commercial paper after last June.
As the prices of subprime-related securities began to fall last summer, off balance sheet vehicles, such as SIVs, started to have difficulties in rolling over these ABCP liabilities. Those that could, notably conduits, started tapping liquidity lines from their backer banks.
In one sense, this is all old news. But it’s come back into focus under the badge of VIEs, or variable interest entities – a catch-all terms that covers almost any kind of SPV, including SIVs and conduits.
The key is that these vehicles need only show up on a bank’s books when they hit trouble – even if there is theoretical backing in place. Hence the odd surprise over at Citi last year.
This is then what’s known as “involuntary asset growth” – a phenomenon that was expanding banks’ balance sheets just as they sought to put the squeeze on. They naturally cut off lending where they could.
As if SIVs et al weren’t already in the financial dog house, this could yet prolong our credit troubles:
The question is how far the contraction of balance sheets have to run in the current crisis. Given the recent disclosed losses at the major banks arising from the subprime crisis, it would be reasonable to conjecture that the contraction of balance sheets still has some way to go.