Tuesday, November 13, 2007

[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -32.4%]

Banque de France, the French central bank, has just published a Focus paper on "Ten key words to make sense of the crisis". First on the list: the L-Word — liquidité. The paper notes the paradox of "co-habitation": abundant macroeconomic liquidity coupled with a liquidity squeeze in certain segments of the global capital markets. The key thing to keep in mind is that "various types of liquidity exist":

Macroeconomic liquidity differs from market liquidity: the former is defined as the quantity of monetary assets available in the economy, while the latter constitutes the market's ability to absorb the sale of assets rapidly without a significant fall in prices. While the former is permanent and results from medium-term economic developments, the latter is more fragile; its existence is contingent on the confidence on the quality of the assets traded or in that of the counterparties involved and may, without this confidence, dry up suddenly.

Market liquidity, however, appears to be an increasingly important determinant of bank liquidity, i.e the ability of banks to meet their liabilities or unwind or settle their positions. Banks' growing use of market financing and the size of their off-balance sheet exposures have indeed increased the volatility of bank liquidity, making banks more reliant on the provision of liquidity by the central bank during periods of market stress.

The recent turmoil has showed that a system based on market financing is more vulnerable to a sudden drying up of liquidity than a system of bank intermediation is to traditional bank runs, even though the latter may still occur in the absence of ayhsyan adequate system of guarantees.

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