Timothy F Geithner: Liquidity and financial markets
Keynote address by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the 8th Annual Risk Convention and Exhibition, Global Association of
Risk Professionals, New York, 28 February 2007.
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We have been in a period that market participants have characterized as one of exceptional liquidity.
This is both a reflection of, and has contributed to, the ongoing expansion in the world economy. I
want to focus my remarks today on the role of liquidity in markets, and what supervisors and market
participants can do to make markets more robust against the shocks that we know will occur from time
to time. These remarks are directed to a general phenomenon related to developments in the financial
markets in recent years, and not to the specific conditions of the moment.
Liquidity plays a central role in the functioning of financial markets. Structural changes in the financial
system that have been underway for some time increase the importance of market liquidity. The
allocation of capital increasingly relies on securities markets, where funds for investment in the real
economy are raised through the direct issuance of securities to investors. A greater diversity of
financial institutions, institutions other than banks, now play a more active role in the provision of credit
and liquidity.
Liquidity can mean many different things. One dimension of liquidity is the availability of credit or the
ease with which institutions can borrow or take on leverage. This is generally referred to as funding
liquidity.
Another dimension of liquidity is the ease with which market participants can transact, or the ability of
markets to absorb large purchases or sales without much effect on prices. This is what is generally
called market liquidity.
Although these two concepts are distinct, they are closely related and are often mutually reinforcing.
Fundamentally this is so because when funding liquidity is abundant traders have the resources with
which to finance trading positions that smooth price shocks and make markets liquid.
In practice, this mutually reinforcing behavior is driven by a complex array of factors, including the
degree of leverage embedded in the markets at any given time, the difficulty that lenders face in
discerning whether a surge in volatility is driven by a transitory shock of some kind or a permanent
shock to fundamentals, and risk management practices.
Institutions manage the credit risk in their trading-related exposure by requiring some counterparties to
post collateral or margin. Typically, institutions require of hedge fund counterparties both initial margin
against potential loss and variation margin, which requires payment to cover any decline in the value
of the position. If the position declines in value, the counterparty will have to meet margin calls. If it
does not have enough liquidity on hand to meet those calls, it will have to liquidate other positions to
raise the requisite cash. The failure to satisfy such a margin call could lead to the liquidation of the
position.
This approach to risk management can transform credit risk into liquidity risk. In most circumstances,
the impact of this is unexceptional. Other institutions will find the new prices attractive and step in and
buy. In exceptional circumstances, however, as creditors and counterparties seek to reduce their
exposure to future losses, actions intended to limit individual exposure to risk may instead increase
overall risk.
We do not know very much about what makes markets more or less vulnerable to this type of acute
shock. This is in part because liquidity itself is not easy to measure.
A broad range of indicators tells us something about funding liquidity, including growth in monetary
aggregates, in financial assets and different forms of borrowing or credit. Other measures, such as
movements in bid-ask spreads, the level of interest rates, changes in asset prices and risk premia,
along with the level of volatility and expectations of future volatility, and turnover volume or other
measures of market depth, help us evaluate market liquidity.
Yet none of the measures provides a reliable way of judging how vulnerable markets are to a reversal,
or the scale of damage that might accompany a reversal.
These measurement limitations are similar to those that make it difficult to judge when, and by what
magnitude, asset prices deviate from fundamental values at any given point in time.
In the case of liquidity, the shortcomings of our analytical tools are magnified by the difficulty of
measuring leverage or identifying potential concentrations in the financial system. This has always
been challenging, but the growth in the overall size of private pools of capital and the degree of
embedded leverage that exists in many derivative instruments makes this more challenging today.
When market liquidity and funding seem abundant, this is likely to be observable in things we can
measure, like interest rates and credit spreads. And when liquidity ebbs, the effect is conspicuous in a
range of observable market prices and volumes. But we do not have, and probably never will have, a
set of indicators that offers the promise of predicting when liquidity conditions will reverse, or when
markets are particularly vulnerable to a more acute decline in liquidity.
In this sense, liquidity is like confidence. And, like confidence, liquidity plays a critical role both in
establishing the conditions than can lead to a financial shock, and in determining whether that shock
becomes acute, threatening broader damage to the functioning of financial and credit markets.
What role can policy play in reducing the vulnerability of markets to this type of dynamic?
Of course, central banks have a range of instruments they can use in the event of a crisis. By injecting
liquidity into the system, and thus strengthening confidence, they can reduce the risk that temporary
liquidity problems will result in default by otherwise solvent institutions, or damage to the payment
system or credit process.
But what can policy makers do ex ante to limit the risk of crisis? The most powerful instruments we
have are those that affect the strength of the basic, fundamental shock absorbers in the financial
system. When capital and liquidity cushions at the major institutions are strong, then markets as a
whole are less vulnerable to the adverse spiral of asset price declines, increased volatility, and
declining liquidity. And when the operational infrastructure is robust, markets will be able to absorb
larger shocks and sharper changes in risk appetite with less risk of broader contagion. These shock
absorbers are substantially stronger today than they have been in even in the relatively recent past.
These issues are the principal focus of day-to-day supervision and market oversight in the major
financial centers around the world. The Federal Reserve is actively involved in a range of efforts,
working closely with the primary supervisors of the major global financial institutions and the critical
parts of the financial infrastructure, to encourage further progress.
In this context, we are working to put in place a stronger regulatory capital regime and to strengthen
the capacity of firms to absorb losses in stress conditions. We are encouraging more sophisticated
and more conservative management of credit exposures in over-the-counter (OTC) derivatives and
structured financial products, as well as of exposures to hedge funds. And we are encouraging a
range of efforts to modernize the operational infrastructure that underpins the OTC derivatives
markets, and to improve the capacity of market participants to manage adversity.
These efforts will all contribute to a more resilient system, one that is better able to withstand the
effects of a major decline in asset prices or deterioration in credit.
Are there other tools that policy makers and market participants could use to address this risk?
Some policy makers have argued that public disclosure of information could help reduce the risk of
future systemic financial crisis, by preventing the buildup of "excessive" leverage or concentrations of
risk.
The principal focus of attention, as in the immediate wake of the failure of Long Term Capital
Management, has been on two quite different types of public disclosure.
The first is information that would make it easier to evaluate the overall leverage or risk profile of major
hedge funds and their counterparties, and thereby judge their vulnerability to a sharp movement in
asset prices. The second is information about the actual positions of individual funds or institutions:
information that would make it easier to identify concentrated exposures to specific risk factors, and
thereby assess more accurately the potential impact of the failure of a major fund or institutions on the
market as a whole.
These pose very different challenges and offer different benefits. There are a number of crude
measures of overall risk profile that, if disclosed to the market, would give counterparties information
they do not now typically get about the risk of failure of the fund. One example is data on the size of
daily variations in net asset value, VAR, or profit and loss over the previous quarter. This type of
information would not reveal proprietary information about trading strategies or otherwise create
substantial disincentives to risk taking. Although these would provide some information on the overall
risk profile of the fund, they would be lagging indicators, and they would carry the usual risk of
providing false comfort in some circumstances and excessive concern in others.
Adopting such measures would give the institutions that provide financing and leverage to hedge
funds a somewhat greater capacity to judge their direct risk to those funds. But that is not their
principal challenge. The institutions already know the positions they are financing, and they can use
the usual range of tools to measure the potential exposure, net of collateral, in those positions. And
where they do not feel they have adequate information to evaluate the overall risk profile of the fund,
they can manage that risk by taking less exposure, by requiring more margin, or by building a greater
cushion of protection against overall risk. So the potential gains from a disclosure regime of this type
would be limited, at least as compared with the cost of trying to put such a regime in place on the
global scale that would be necessary to make it effective.
By far the greater challenge is to assess the potential impact of the failure of a major hedge fund on
the firm's other exposures and other counterparties. This is a question about how correlated the firms
other positions are to the risks the hedge fund is taking. It goes beyond the firm's direct credit
exposure to the hedge fund, to the fund's overall risk profile. Large hedge funds typically use multiple
prime brokers, and they are, of course, reluctant to disclose to those institutions real time information
on their overall positions and trading strategies. So the banks and investment banks do not generally
know what their overall exposure to credit and market risks might be in the event that a large fund is
forced to liquidate positions.
This knowledge gap has led many to advocate the provision of information on actual positions of the
major funds, perhaps aggregated by a third party. According to the proponents, this would help market
participants and regulators to identify potential concentrations or crowded trades, and that knowledge
would help diffuse them before they became a problem.
This type of transparency has understandable and enduring appeal, but it is unachievable. There is no
feasible way to try to capture in real time the rapidly changing exposures of different institutions to
different risks in any meaningful fashion. No one with access to that information could make sensible
judgments about the level and nature of actual concentrations and whether the risks are excessive.
We continue to explore ways in which the provision of greater information to counterparties and to the
markets more generally could help reduce vulnerability to financial crises. For now, though, the
practical limitations on achieving greater transparency underscore the importance strengthening the
robustness of the shock absorbers in the financial system. We are not likely to ever be in a position
where we have the capacity to identify the source and estimate the probability of future financial
shocks. And policy makers are unlikely to ever be in a position to diffuse concentrations of risk or
crowded trades ahead of a crisis. The most sensible thing we can do is to improve the capacity of the
core of the financial system to handle adversity, and this requires continued focus on improving the
strength of the capital and liquidity cushions, as well as the market infrastructure.
Let me end with a few quick thoughts on the role of monetary policy in this context. Can monetary
policy play a pre-emptive role in reducing the vulnerability of financial markets to the type of dynamic
we saw in 1987 and 1998?
Central banks cannot realistically hold out the prospect of using monetary policy to prevent asset price
bubbles, conditions of "excess" leverage in parts of the financial system, or other factors in markets
that might lead to the types of positive feedback dynamics that were at the heart of some past crises.
And yet many of the observations made about liquidity and market conditions over recent years have
potential implications for monetary policy. Changes in risk premia, the level of asset prices, credit
spreads, and interest rates, and in realized and expected volatility of asset prices - these can all affect
the pace at which overall demand grows, and can therefore potentially affect future inflation.
In discharging their responsibilities for the maintenance of price stability, central bankers need to be
eclectic in looking at a range of different ways of measuring the stance of monetary policy, and its
effects on the future path of growth and inflation. No indicators of liquidity or overall financial conditions
provide a ready guide to judgments about monetary policy. But all these indicators merit careful
attention, and they strengthen the argument against narrow or mechanistic approaches to thinking
about the monetary and broader economic outlook.
Ultimately, though, ex ante judgments about leverage, concentrations and liquidity risk will continue to
prove elusive. Our principal focus should therefore be not in the search for the capacity to
preemptively diffuse conditions of excess leverage or liquidity, but in improving the capacity of the core
of the financial system to withstand shocks and on mitigating the impact of those shocks. And, as
always, central banks need to stand prepared to make appropriate monetary policy adjustments if
changes in financial conditions would otherwise threaten the achievement of the goals of price stability
and sustainable economic growth.
Thank you.