Relationship between Market Liquidity Risks and Funding Liquidity Risks for International Banks - Assignment Example

Exam questions for international banking Contents Contents 2 Answer The relationship between market liquidity risks and funding liquidity risks for international banks 3 Answer 2: The driving forces of modern financial crisis 6 Answer 1: The relationship between market liquidity risks and funding liquidity risks for international banks Market liquidity and funding liquidity are the two major components that determine the overall liquidity and resiliency of any financial market. Market liquidity refers to the cost of selling any asset. This is related to the bid-ask spread which is used to measure the amount of money that any individual or institutional trader would lose if one unit of any asset is sold and immediately bought back. Market liquidity may also refer to the depth of the market which indicates the number of units that a trader can buy or sell at the prevailing bid price or ask price of the asset without having to shift the price. The ability of the trader to move the markets by influencing the bid and ask prices of the financial instruments and assets is also a factor that determines the liquidity of the market. Often a deep market is found to be more stable because large orders are required for changing the bid and ask prices of assets. In case of internationally operating banks, the market is generally deep and as such, price movements are greatly controlled by the entities of the market. Market resiliency is an important element related to the liquidity level of any financial or capital market. Market resiliency is used to indicate the time that will be required for the asset prices that have decreased to increase to the desirable extent. Figure 1: Measures of market liquidity. Funding liquidity risks in banks are primarily based on the risks associated with cash flow management. Funding liquidity is used to describe particular features of a financial agent within a market. It also refers to the ability of a trader or financial agent to meet the obligations that may arise with relation to financing of the assets and loans within the market. Funding liquidity is a unique binary concept which is distinct from market liquidity. The international banks generally manage the funding liquidity risks by managing the Line of Credit (LOC) of the banks. The banks have to control both the liquidity of the assets and the availability of cash inflows in order to ensure that they can mitigate the volatilities and resiliencies within the financial market in which they are operating. In case an international bank holds tradable assets which are perfectly liquid in nature, then the banks also score high in terms of funding liquidity. However, market liquidity may be affected by external factors in the market like regulations, trading volumes, price fluctuations etc. and thus may directly impact the funding liquidity of the market to change as well. In case a considerably large portion of the assets of a bank suddenly becomes illiquid in nature while the banking institution remains solvent, then the bank will not be able to meet the short term obligations and thus would become financially distressed sooner or later. This was the same scenario which occurred in the case of a number of international banks and financial institutions during the Great Financial Crisis (GFC) of 2008 when the highly liquid market dealing in mortgage backed assets dried up within a short time due to illiquidity of the assets available to the banking and financial institutors. The banks have to mitigate the market resiliency and illiquidity of assets by controlling the trading volume of assets which is a major indicator of the liquidity level of a financial market. Also, the banks manage the exogenous market liquidity by using the bid–ask spread i.e. the difference between the bid prices and ask prices of the assets and financial instruments. Market liquidity refers to the ease with which assets can be traded in a market. In contrast, funding liquidity refers to the availability of suitable amounts of funds and funding sources in a market. The relationship between market liquidity risks and funding liquidity risks is complicated and multidimensional. This is because the relationship between market liquidity and funding liquidity is also much complex. It can be said that market liquidity and funding liquidity are greatly interconnected and influence each other. The funding liquidity of a trader and the market liquidity of an asset are often strongly correlated. While funding liquidity is often an influential factor in enhancing market liquidity, market liquidity is also necessary for easing funding restrictions by improving the collateral value of assets that are being traded in the market. As such, market liquidity is also a significant driver of the availability of funds and financing sources in a market. A restricted funding liquidity prevailing in a market may lead to increased illiquidity of the market i.e. it would be difficult to sell the assets in the market at normal or low prices. This means that the assets would be sold at fire sale prices which would make the assets highly volatile in terms of price and sales volume. As the volatility of the assets in a market increase, so does the illiquidity of the market. The relationship between the funding liquidity risks and the market liquidity risks in case of international banks can be further explained through the use of the following case of the banks in New York in the pre First World War period. This case examines how funding liquidity risks and constraints can have significant effects in the other ancillary factors like market liquidity, stock returns, market volatility and stock prices in a financial market. In this period, the funding risks and constraints of the financial market of the United States of America was largely determined by the agricultural stocks and assets that were traded in the market. The banks in the country used to deposit reserve amounts and assets in the financial institutions of New York and surrounding centre cities. During this period, the international banks in New York City used the reserves as the funding sources to extend their credits in the form of loans for the speculators. In the cases of large withdrawals from the country banks, the New York City banks were given the right to call the loans in order to increase the reserve position of the banks which often led to the incidences of bank run and subsequently market illiquidity and financial downturns in the market. Answer 2: The driving forces of modern financial crisis The last three decades gave seen a number of small and large scale financial activities in the advanced economies Also, the modern day financial crisis have been varied in nature with different underlying driving forces and impacts on the domestic and global economies. The modern financial crises are caused by factors like real estate lending, housing bubbles, credit defaults, mortgage credits, the ways in which banks and other financial institutions mange and report their financial statements etc. Real estate credit and mortgage loans are found to be major drivers of financial downturns in advanced economies like the United States of America. The fact that the international banks and financial institutions operating in the modern day economies follow business models that resemble the real estate funds is a reason that has alerted the way the economies of different countries function. The banks generally borrow from the capital markets and public entities in order to invest into assets which are majorly linked to the real estate markets. As such, the functioning of the banks including the credit loan policies and mortgage systems are much dependent on the real estate markets. Also, by investigating into the composition of the credit loans and funding capabilities of the banks and other financial institutions, it becomes clear that the accelerating rate of increase in mortgage lending and real estate asset based lending to the households has been a critical driving force that has led to the stark modifications in the balance sheets of the banks and other ancillary financial institutions. The financial activities like mortgage lending and credit defaults have been identified as a primary cause for the Great Financial Crisis (GFC) of 2008 which was mainly triggered by the housing bubbles. Real estate credits have also become an important influence of the financial fragility of the economic and financial situations in a nation. There are two main types of crises noted in the modern economies. These are banking crisis and financial crisis which are interconnected and overlapping. Also, in some situations, one of these two crises is triggered by another. The vulnerability of banks and financial institutions is a main reason why financial downturns are caused in an economy. The mismatch between the maturity of assets and liabilities, especially the short term liabilities and the long term assets held by a bank is also a significant driving force that triggers banking crises. Apart from this, the risks of contagion in the economy like systematic risk are another driver of the banking crisis in an economy. The systematic risks refer to the risks of liquidity and credit problems of one or multiple entities in the financial market that leads to the creation of substantial market liquidity, credit or funding problems for the participants in the overall financial system. The trend of excessive risk taking by the banks can also be identified as a reason for the modern financial crises. The banks operating in the advanced economies are financed by a number of relatively uniform and small scale depositors. As such, the financial safety net becomes weaker because the liquidity and market resilience becomes dependant on a fragmented and wide base of market participants. The macroeconomic policies in a nation also impact the financial stability of a market in major way. Often the large scale economic downturns have been found to be caused by the macroeconomic instabilities in a country coupled with a period of varied financial deregulation. The impact of these macroeconomic instabilities and financial deregulations are boosted by the rapid increase in the asset prices and bank credits. These factors seem to affect the economy in a double triggered manner which leads to a sudden collapse in the financial markets. Financial liberalization has led to deregulations in the economies of various countries which have allowed new banks to enter into geographical locations where they have less or no experience of functioning. The financial deregulations also influence changes in the ownership and institutional structures within the economies which affect the ways of a reacting to financial and capital risks in the markets. Apart from this, deregulations in the economy also lead to the introduction of new assets and financial instruments which instigates traders and other participants in the financial markets to take up risks without paying adequate attention to the negative consequences or downside potentials of investment in these new financial instruments. The liberalization of entering into the banking industry has led to increased competition among the banks and other financial institutions, the liberalisation of interest rates have increased the market risks and repayment risks and thus have led to increased chances of credit defaults in the financial markets. Also, the lifting of existing controls in the economy to monitor the functioning of the banking institutions have expanded the chances of credit default and heightened market risks and vulnerabilities. All these factors or some of these factors act in a combined manner to lead to financial instability which if unchecked cause financial crises in the regional and global economies. The expansionary fiscal and monetary policies cause economic bubbles which are pricked by the tightened policies and which triggers consecutive activities like the borrowers being unable to repay the loans. This further leads to banks accumulating high levels of non-performing loans and as a consequence the banking institutions curtailing the lending facilities. The decline in the trading value of the collaterals further aggravates the credit default and credit stringency problems. These can also be cited as strong driving forces that lead to economic downturns. The Global Financial Crisis of 2008-2009 that started in the United States of America was triggered by the mortgage lending and credit defaults followed by the collapse of major financial institutions. The subprime lending of the mortgage backed loans was identified as the most powerful driving force that instigated the crisis. Overleveraging of the assets and overvaluation of the mortgage backed loans have also been some common drivers of the financial crises over the last few decades. Read More