Financial crises occur because of the joint effects of leverage and illiquidity. Leverage causes forced liquidations, and illiquidity creates the downward cascades and contagion that result. The regulations that have come in the wake of the 2008 crisis have focused on stemming leverage, but have largely ignored liquidity. In fact, in their focus on leverage they have unwittingly heightened the vulnerabilities from liquidity. In reducing the balance sheet of the banks, Basel has also reduced their capacity to hold inventory. In moving the banks away from proprietary trading, the Volcker Rule has reduced the profitability of the broker-dealers’ market-making function, reducing the incentive to take on positions during periods of high volatility and one-way flows.
Unlike leverage, illiquidity is difficult to assess, so its risks are largely hidden. It is true that day-to-day liquidity is readily visible and can be measured by looking at indicators such as bid-offer spreads and average daily volume, but day-to-day liquidity is not what matters. The liquidity that matters is what is available during periods of market dislocation when liquidity demand is many multiples of what is normally seen. And what happens in a typical day gives us little sense of that, not only because the size of the flows is smaller, but also because trading is carefully managed in the normal market periods in order to avoid moving the market.
