International Banking: Funding Liquidity and Market Liquidity - Term Paper Example

? International Banking Lecturer: Introduction The 2008 economic and financial recession sent the world’s economy into financial shock that has since then taken a great deal of financial resolutions as put forth by the world economists to ensure financial recover by a number of countries and enterprises. It marked the first global financial crisis to be experienced in the 21st century. From its impacts, it gained the name the Great Recession. A crisis is an urgent, difficult, or dangerous situation as may be rendered by factors such as the financial, economic, and political instabilities. The 2008 crisis is considerably the first crisis in the era of globalization, as caused by a number of factors which include funding liquidity, and market liquidity (Kolb, 2009, p. 10). Funding liquidity is the availability of sufficient cash in the capital deposit of a financial institution. This means that funding liquidity risks occur whenever banks cannot fund their own businesses. Market liquidity, on the other hand, takes into considerations issues to do with trade institutions which are easily able to do business within the available markets; therefore, market liquidity risk factors are the difficult situations when any market is not sufficient enough for easy trade activities (Pedersen, 2008, p. 13). The roles of Funding Liquidity and Market Liquidity in the 2008 Crisis According to Strahan Philip (2012), funding liquidity risks and market liquidity risks contributed much to the occurrence of the 2008 financial and economic downturn. Towards the end of 2007 and the beginning of 2008, the consequences of banks giving liquidity to loaners and creditors in the world’s leading economies was felt throughout the globe. The banks in the USA began lending loan liquidity to people; this led to weakening of their capital bases. It additionally exposed banks to funding liquidity risks, which eventually lead to bank runs. Bank runs usually occur whenever banking institutions become vulnerable, and their creditors withdraw for fear of losing their capital. A result of these is depositors losing faith in their respective banks, after which, they start to withdraw their deposits from such banking institutions. An instance of bank run is when one of the American Electric Power Suppliers withdrew their deposit, worth $2 billion from the JP Morgan Chase. This saw the JP Morgan Chase bank running out of cash in its deposit pots. The issue of securitization is another cause of the financial crisis. American banks came into one pool in order to create a sense of security while giving out irresponsible loans. This proved dangerous since the banks gave out risky loans to many individuals who could not afford to service these loans at high interest rates as was expected of them (Pinyo, 2008, pp. 1-6). Due to runs, the banking institutions got involved into the trend of cash borrowing in order to create more securitization. As a consequence, property prices started fluctuating, thereby causing panic even in the Sub-prime mortgage market (Rhodes & Stelter, 2010, p. 32). Banks that did not have enough cash in their accounts began repossessing their high value properties such as buildings. Bigger banks, on the other hand, started to buy securities from the minor banking institutions with the intentions of saving the economic situation as had prevailed. However, this instead resulted into greater damages within the real world economy (Weisberg, 2010, p. 46). At far, all these economic turnovers resulted into funding liquidity risks and market liquidity risks within the banks themselves, hence scaring away a number of investors who then reacted by withdrawing their deposits; and thus, commodities prices fell to the extreme levels. The chart below indicates Liquidity Spiral as caused by the market and funding liquidity risks. Sources: (Pedersen, & Garlean, 2007; Pedersen, & Brunnermeier, 2008) How to measure bank funding liquidity risk and market liquidity risk There are several ways of measuring funding and market liquidity risks that are provided by the world economists. Funding and market liquidity risks, in the first instance, are measured using the bid offer spread. Bid offer spread is defined as a deep comparison between the prices quoted by the banks in the market and prices of the ready auctioneers. The magnitude of the bid offer spread is the measure of the funding and market risks. This difference is normally measured in figures which indicate the amount of the funding and market risks. It means therefore that the wider the difference, the bigger the funding and market risks. Whereas whenever the difference is zero, it means that a market with no operating cost, otherwise referred to as a frictionless market (Chew, 2012, pp. 58-87). The second way of measuring funding and market liquidity risks is through Market Depth. A Market Depth is defined as the extent of ease with which to identify someone to partner with in trade activities. The deeper the market, the easier it is to find trading partners. Market depth is determined by the value of order that is required to shift prices in the market. Therefore, the larger the value, the deeper the market and lesser the funding risk. Immediacy, which is the shortest duration of time needed to find a client to sell a given property at a given price, is also used to measure the market and funding risks. The shorter the duration, the less the number of risks involved. The last method of measuring the funding and market liquidity risks is resilience of the market prices. The speed at which the prices in the market go back to the normal prices after major trade activities is a measure of liquidity. The faster the speed of returns, the bigger the amount of risks involved. Interactions of bank funding liquidities and market liquidities based on datasets Seamless relationships between bank funding liquidity and the market liquidity exist. As discussed in the above question, funding liquidity (which is the availability of sufficient cash in the capital deposit of a banking institution), influences the value of Market liquidity and (on the other hand) means that a trade institution is easily able to trade in the market (Pedersen, 2008, p. 13). The whole concept can therefore be perceived that in an instance of funding liquidity risks, when any bank cannot fund its own business, the market liquidity risk will also follow, and thus, the banking institution will not have an easy time getting auctioneers and there will be difficulty in trading activities among the affected banks. The interaction between funding liquidity and market liquidity is depicted in the dataset that is attached to this assignment. This relationship is discussed below. The dataset shows varying values of Ted spread among the different countries that are included in the table. Ted spread, which is the difference between the rates of interest between T-bills and interbank, are indicators of credit risks in a banking institution (Francis, 2013, p. 2). An instance of a credit risk in a bank indicates an approaching funding risk. Normally, whenever there are perceived credit risks, bank runs are also expected. This will in most instances force the banking institutions to charge higher interest rates or to take lower returns. The table shows that countries with higher values of Ted spread have got lower returns on monthly basis. Meaning that any increment in the funding liquidity risks, leads to an increase in market liquidity risk, and hence, a reduction in trade activities and eventually too low monthly return in such countries. In a country like Ireland, the value of tedspread was at 6.25 and the monthly return at 12.67 in august, 2006. In the following month of the same year, the tedspread increased to 30 while the return fell to 11, a clear indication of the inverse relationship between tedspread and monthly returns. Credit default swap (CDS), which is the financial agreement involving credit sellers and debtors, is also use by financial specialists to closely monitor the credit risks involved in the economy. It like an instance of selling on credit, whereby, if the debtor defaults the loan, the lender will take possession of the defaulter. Among the countries included in the data set, the value of CDS is quite low and constant for most of them. The tables also show fluctuating trends in the value of CDS during some months, as well as the fluctuation in the rates of monthly returns (Francis, 2013, p. 2). This justifies that an increase in the value of CDS indicates presence of many load defaulters in that given country, hence, an increase in funding liquidity risks due to the reduction in the capital base of lending banking institutions. In situations where the banks are forced to take the possession of CDS defaulters, there will be an increase in the market liquidity risks, leading to less trading activities. The results of this will be low monthly returns on stock. This is evident in countries like Italy where the value of CDS is increasing, thereby decreasing the monthly returns on stock. The rates of return on equity are also seen to be fluctuating among the several countries that are included in this data set. ROE of a country indicates the profitability of that country’s banking institution (Loth, 2013, pp. 27). A higher ratio of the ROE means that the banking institutions or the countries are properly using and managing their available resources. The data set shows that the countries included are effectively using their resources and are in turn reaping high values of ROE. The ROE of these countries are at above 20%, a level that is considered very high by financial analysts. This means that the banking institutions in these countries are attracting high numbers of investors. The bottom line of this is that the market liquidity in such countries is higher to ensure that ROE remains at the higher levels. The figure below is a chart showing TED spread of LIBOR banking institution for a three-months-duration, and for American Treasury bill. This chart is used to measure the credit risks of the US economy. The spread between the Treasury bill and LIBOR continue to widen, showing that their clients have no faith in the banking institutions. Source: Macro trends, 2013. The above graphical representation of the TED spread shows a large disparity between the LIBOR and the US treasury. The indicators suggest that the US government has to incur some costs before borrowing credit even for shorter terms. The existence of the large gaps between these spreads will automatically create anxiety among the banking institutions in USA. This will in addition make the banks to pay more cash to borrow loans since lenders will be scared of risking their investments. Conclusion The financial and economic downturn affected everyone; the wealthy, the middle class, and more deeply the poor. All these were because of the: global fallout from the financial crisis in the United States; a replete of the housing bubbles in the United States and in other larger economies; progressively more restrictive monetary policies in several countries; towering commodity prices, and stock market volatility. Funding liquidity and market liquidity are closely related since the occurrence of one influence/ leads to the other. Therefore, they ought to be managed in good time, as a major step towards the prevention of another global financial crisis. Liquidity crises are developed in a chain of liquidity spirals, whereby increased margins, market losses, the rise in volatility levels and the tight risk managements relate to each other. Hence, these two categories of liquidity call for active management at the very early stages of the economic control. BIBLIOGARAPHY Chen, W. 2012. Funding Liquidity Risk: from measurement to management. SAS Institution Inc. Taiwan, pp. 58-87. Francis, T. 2013. What Happened to the Ted spread?, p.2 http://www.npr.org/blogs/money /2012/07/09/156385580/what-ever-happened-to-the-ted-spread Kolb, R. 2010. A Lesson from the Financial Downturn: Consequences, Causes and Our Economic Future. John Wiley & Sons, pp. 10 - 29. http://www.globalresearch.ca/ index.php?context=va&aid=9191 Loth, R. 2013. Profitability Indicator Ratio: Return on Equity, pp. 23-45 http://www.investopedia.com/university/ratios/profitability-indicator/ratio4.asp Pedersen, H., L. Liquidity Risk and the Current Crisis, p.13 http://www.voxeu.org/article/understanding-liquidity-risk-and-its-role-crisis Pinyo, 2008. What Caused the Economic Crisis of 2008? pp.1-6 Rhodes, D. & Stelter, D. 2010. Stepping up out of the Great Recession: Winning in Slow- Growth Economies. Mc Gro-Hill. New York, pp. 28-42. Strahan, E., P. 2012. Liquidity Risk and Credit in the Financial Crisis. http://www.frbsf.org/economic-research/publications/economic-letter/2012/may/liquidity-risk-credit-financial-crisis/ Weisberg, J., 2010. What Caused the Economic Recession: The 15 Best Explanations for the Great Recession, p. 46. http://www.slate.com/articles/news_and_politics/ the_big_idea/2010/01 Read More