BIS Working Paper No.293 issued in November 2009 deals with the very interesting recent market happening – liquidity crisis. It also covers some ten propositions about liquidity crises.
While going through the same, I was looking for ways to handle them in future through appropriate, perspective and predictive technology support.
“Market liquidity is defined as the ability to trade an asset or financial instrument at short notice with little impact on its price; funding liquidity is defined as, more loosely, the ability to raise cash (or cash equivalents) either via the sale of an asset or by borrowing against it”.
A liquidity crisis is defined as a sudden and prolonged evaporation of both market and funding liquidity, with potentially serious consequences for the stability of the financial system and the real economy.
Proposition 1: Beyond obvious idiosyncratic elements, all liquidity crises share at least two key features; one concerns their dynamics once strains emerge and the other, their causes.
Technology response 1: Technology should support and provide guidance notes as and when such strains in the market place occur through the use of appropriate of Business Intelligence Tools. Academically everyone is endowed with adequate knowledge on what causes such liquidity strains and they can be easily mapped into the BI Tools.
Proposition 2: Contrary to the widely held view, the development of financial markets has increased, not reduced, the demand for funding liquidity. In other words, a market based financial system is funding liquidity hungry.
Technology response 2: One can map this directly to the leveraging ability of the market and its capacity to create funds. Technology can support study of such leverage movements in the market place, in the specific asset class and even down at organizational levels and with suitable prescription of leverage limits it can monitor the performance.
Proposition 3: The role of Payment and Settlement Systems (PSS), a key element of financial infrastructure, in preventing liquidity crises is important but limited.
Technology response 3: Such limitations cannot be overcome, as long as different countries follow different settlement cycles and also real time gross settlements are not facilitated. Technology can directly facilitate smoother payment and settlement processes across the globe, once these basic issues are sorted out.
Proposition 4: In order better to prevent liquidity crises, there is need to improve buffers in the system
Technology response 4: The liquidity buffers depend on three dimensions: the severity and characteristics of the stress scenarios, the time horizon and the characteristics of the assets in the buffer. Technology can provide an appropriate framework for deriving the overall level of the buffer as well as its relative composition from stress tests conducted over a long time horizon and their short term impact.
Proposition 5: It would be desirable to consider putting in place (variable) speed limits
Technology response 5: After the establishment of such speed limits, technology can be used to monitor holding large concentrations or build-ups in particular assets. It can also proactively facilitate liquidation of large concentrated positions particularly less liquid assets.
Proposition 6: Retail Deposit Insurance Schemes are not best suited to prevent liquidity crises
Technology response 6: Though there could be no direct technology response for this proposition, retail deposit build-ups through sustained efforts in the long run can provide an excellent core liquidity buffer in normal times and it also enhances the efficacy and profitability in the operations. And of course, we also know to service and support such retail deposit clientele, technology is the key.
Proposition 7: The existence of the central bank framework to provide liquidity is a double edged sword
Technology response 7: Central banks come in as ‘the lender of the last resort’ when the banks could not meet their requirements through their normal operations and / or other external sources. Technology can provide a competitive framework for availing external support to meet liquidity requirements and also to predict when to refund/return the support received from central banks. This can lead to appropriate managerial responses. Yes. Definitely technology can facilitate in the decision making.
Proposition 8: In a liquidity crisis, the key to the effectiveness of central bank (funding) liquidity operations is the intermediation role played by the institution, not the size of the net additions to the stock of reserve balances held with the central bank (i.e. increases in the monetary base)
Technology response 8: By predicting accurately such liquidity crisis and providing an appropriate frame work for dealing with such temporary liquidity crisis, business intelligence tools and technology can caution the intermediary institutions in their liquidity management.
Proposition 9: There is a need to develop principles for the provision of funding liquidity to address protracted market wide liquidity crises.
Technology response 9: Technology can come out with and build the business rules in it once the principles are developed and these business rules can facilitate the financial institutions in their liquidity management
Proposition 10: There is a need to reconsider also the possible role of monetary policy (interest rate setting) in the prevention of liquidity crises.
Technology response 10: The role of interest rate and prevailing inflation in the overall monetary management cannot be under estimated. BI tools and technology can help map, monitor, predict and proactively propose suitable way forward to meet emerging challenges in the market.
Conclusion: The recent global financial crisis has highlighted the importance of liquidity management in financial institutions – avoiding the temptation to build long terms assets through short term funding with the resultant inter generational shifts in pains and pleasures. Surely this effort by BIS should make the financial institutions to look back and review their operations and make amends, at least now, to get into the future.
Otherwise they may be forced to write their tombstone.