Financial Fragility, Capital Regulation and Bank Testing - Essay Example

 The bank illiquidity and simultaneous surplus returns on the stock have depressing and considerable relationship. Increase in illiquidity can result to investors’ shift to banks that have high liquidity or increase in stock return increases illiquidity (Acharya & Pedersen, 2005 p. 378). The future expectation of illiquidity in bank influences the future excess returns of the stock positively. The instantaneous excess stock returns are considerably strong during financial stress due the impact of systematic liquidity risk. However, bank funding liquidity risk underpins market liquidity risk (Acharya & Pedersen, 2005 p. 390). Bank mergers can reduce the cost of operation and increase scope of activities thus enabling them to control market and funding liquidity. This document examines the effects of bank mergers on market and funding liquidity and their interactions during the financial crisis. The activities of the bank influence their capacity to control market and funding liquidity (Brunnermeier & Pedersen, 2009, p. 2203). Investors prefer strong institutions that they perceive as being less risky because they are fairly stable during the periods of the economic downturn. Liquidity risk is the risk that a particular asset or portfolio may not be exchanged in the market quickly in order to evade a loss, and it results from uncertain liquidity. Liquidity risk could either be due to the market liquidity or funding liquidity (Brunnermeier & Pedersen, 2009, p. 2204). Market liquidity is the condition whereby the assets cannot be traded in the market due to lack of liquidity in the market. The market liquidity can drain suddenly, interlinked with instability, have cohesion across securities, co-varies with the market, and is dependent on “flight to quality” (Anonymous, n.d., 5). Funding liquidity refers to ease with which traders can obtain funding for assets. The investors require portfolio security with high returns in case the market is illiquid and require return premium for an illiquid security in a situation where the entire market is illiquid (Amihud, 2002. p. 32). Small banks pose high risk to the investor because they may not be able to acquire funding during the periods of the economic downturn. Sometimes traders purchase asset and use it as collateral against borrowings. However, the trader can borrow up to a certain percent of the security value, but not the entire security value. The difference between the borrowed funds and the collateral value (margin or haircut) is funded from the borrowers’ capital that is usually greater than the haircut or margin (Brunnermeier & Pedersen, 2009, p. 2203). The funding liquidity and market liquidity affects each other especially due to tight funding liquidity. This condition results to decrease in market liquidity and an increase in market volatility. This further reduces market liquidity and increases the risk of financing a trade thus resulting to increase in haircut (Anonymous, n.d., 6). The bank mergers results to increased efficiency through input savings, cost reduction and better management. It reduces competition and start offering products that are customer focused. Bank merger is the amalgamation of two or more banks with the effect that only one of them continues to exist while the merged one goes out of existence (Brunnermeier & Pedersen, 2009, p. 2205). The perceived advantage of the merger is lean banking system due to operating and financial synergies. Bank funding liquidity risk and market liquidity risk can be assessed using various approaches. One of them is the use of market depth that refers to the amount of an asset that can be traded at various bids-ask spreads (Brunnermeier & Pedersen, 2009, p. 2225). Sometimes volumes of a given asset that a trader can transact within a given period affect the value of the assets thus the trader should spread the value of transactions evenly to reduce the liquidity cost. "The liquidity cost is the difference between the execution price and the initial execution price” (Acharya & Pedersen, 2005 p. 384). Deep market implies that large volumes of assets can be traded at bid-ask without causing a change in the assets value. Market depth determines market liquidity that consequently affects collateral value and banks funding liquidity (Brunnermeier & Pedersen, 2009, p. 2204). The use of bid-offer spread that examines the amount of money traders may lose by buying and reselling a unit of assets immediately. Market is considered illiquid if the assets value changes due to a change in low volume of that asset (Amihud, 2002. p. 34). Market liquidity is affected by investor’s potential to lose or gain from market transactions. This in turn affects funding liquidity for the assets since banks increases haircut in a more volatile market in order to hedge against liquidity risk. Resilience measure that refers to the momentum at which prices resume their initial status after a huge transaction that caused a change in asset value occurred. If it takes a longer period to resume the initial status, this will result to reduction in market liquidity (Brunnermeier & Pedersen, 2009, p. 2209). Consequently, banks will raise margins thus resulting to reduction in financial liquidity. Banks are susceptible to liquidity risks due to the nature of their activities. For example, the banks finances are contributed from numerous depositors who lack adequate information about the future market (Brunnermeier & Pedersen, 2009, p. 2212). Also, banks are interconnected with other financial institutions such that the issues of credit or liquidity facing one institution directly affect banks and other financial institutions. Finally, there is divergence in the maturity period between short-term assets, and long-term liabilities hence short-term assets cannot e used to finance long-term liabilities. Bank mergers play a significant role in regulating "banking activities in terms of economies of scope and economies of scale" (Anonymous, n.d., 14). "The failure of one bank can affect the performance of other banks because the clients start withdrawing their funds in other banks" for the fear that the same problem may resonate in other banks and result to loss of the depositors’ money (Brunnermeier & Pedersen, 2009, p. 2213). Furthermore, small financial institutions operate under the big institutions thus problem affecting one institution is transmitted to the other institutions resulting to default in the entire financial system. Also, banks and other financial institutions finance each other thus default by one institution to repay the money can result to severe consequences on other institutions (Anonymous, n.d., 7). Banks lose liquidity in case of sudden unexpected cash outflow, loss of liquidity in the market in which that institution trades, poor credit rating of the institution, etc. Market and funding liquidity risks affect each other since institutions cannot be able to acquire funding against an asset that is hard to sell in the market. Similarly, the institutions cannot sell assets in an illiquid market (Amihud, 2002. p. 35). During the financial crisis, banks increases collateral value that results to a reduction in funding liquidity of the investors (Brunnermeier & Pedersen, 2009, p. 2217). Consequently, investors may start to panic and rush to withdraw deposits from the banks with fear that delays may cause cash drain in the resulting to investors’ deposits. Massive withdrawal of clients’ deposits results to market volatility and a reduction in market liquidity since investors cannot easily access credit from the banks. Furthermore, the failure by the banks to advance credit to investors results to a reduction in value of assets and consequently default by borrowers to repay the borrowed amount the interest. The changes in funding conditions in illiquid market results to highly sensitive market liquidity due to margin spiral and loss spiral (Acharya & Pedersen, 2005 p. 389). The margin spiral is whereby the margins increase due to speculators lowering market liquidity due to funding shock (Brunnermeier & Pedersen, 2009, p. 2229). On the other hand, loss spiral occurs due to an increase in market illiquidity as a result of funding shock that results to speculator’s loss of prominent market position and consequent massive disposal of their assets accompanied by further decline in assets value (Amihud, 2002. p. 36). During financial distress, the investors minimize the risk by selling the assets with greater liquidity risk and replace them with less liquidity risk. Stress testing is conducted to establish the importance of market activities on key ratios. Also, it helps to recognize and alleviate risks as well as handle portfolio more efficiently (Brunnermeier & Pedersen, 2009, p. 2225). Stress testing may involve single-factor sensitivity psychoanalysis that aim to establish how the portfolio reacts to a particular economic variable such as stock prices, exchange rates, interest rates, etc. Also, it can be tested through scenario analysis that examines the resilience of institutions and economic structure to the outstanding dealings. In conclusion, the assets liquidity and traders funding liquidity are interdependent since traders provide market liquidity depending on their funding. Due to the interdependence of market and funding liquidity their margins destabilizes under certain conditions thus resulting to liquidity spirals. The anticipated market illiquidity influences the stock excess return or risk premium which implies that the risk premium offers return for the lesser liquidity of stocks comparative to that of treasury bonds. Bank mergers can improve both market and funding liquidity by streamlining banking activities. Bibliography Acharya, V. V. & Pedersen, L. H. 2005. Asset Pricing with Liquidity Risk: Journal of Financial Economics, Vol.77. Pp. 375-410. Amihud, Y. 2002. Illiquidity and stock Returns: Cross-section and Time-series Effects: Journal of Financial Markets, 5. Pp. 31-56 Anonymous, N. d. Small Bank and Local Economic Development. Pp. 1-36. Brunnermeier, M. K. & Pedersen, L. H. 2009. Market Liquidity and Funding Liquidity: The Review of Financial Studies, Vol. 22(6). Pp. 2201-2238. Read More