ESSAY REVIEW. A NEW DEFINITION OF LIQUIDITY: THE GROWTH RATE OF REPOS
. Tobias Adrian & Hyun Song Shin. "Liquidity, Monetary Policy and Financial Cycles", New York Fed Current Trends in Economics and Finance, Vol. 14, No.1, January-February 2008
Henry B. kindly directs my attention to this very interesting piece by Tobias Adrian and Hyun Song Shin. The authors propose of a new definition of financial market liquidity, one that seeks to adequately reflect the nature of the new market-based financial system. The need to come up with a revised definition of liquidity responds to what the authors call "the rapid move toward a market-based financial system in recent years [that has] accelerated the trend toward greater reliance on nontraditional, non-deposit-based funding and toward greater use of the interbank market, the market for commercial paper, and asset-backed securities".
Adrian and Song Shin define liquidity as "The growth rate of financial intermediaries' balance sheets", that is to say "the growth rate of the stock of collateralized lending", or —even more precisely— "the growth rate of outstanding repurchase agreements". They detect a pattern whereby financial intermediaries "increase their leverage during booms and reduce it during downturns". Financial institution leverage is thus pro-cyclical. Unsurprisingly, they find a direct link between the growth of repos and the easing/tightening of monetary policy. While I tend to agree with their analysis, the fact remains that the indicator suggested by Adrian and Song Shin remains a quantity —not a market-based!— indicator. This is the great paradox of this otherwise very enticing piece (*).
(*) Interestingly enough, the VIX index —a truly market-based indicator— is singled out by the authors as the key indicator of "shifts in risk appetite". For a magnificent discussion of the relative merits of market-based indicators relative to quantity indicators, see the already aged, but still immensely valuable book by Manuel Johnson & Robert Keleher. Monetary Policy: A Market Price Approach (Westport, Connecticut: Quorum Books, 1996).