Kevin M Warsh: Market liquidity - definitions and implications
Remarks by Mr Kevin M Warsh, Member of the Board of Governors of the US Federal Reserve
System, at the Institute of International Bankers Annual Washington Conference, Washington, DC,
5 March 2007.
* * *
Thank you to the Institute of International Bankers for inviting me to speak about liquidity in U.S.
financial markets. Certainly, trading activity in recent days has brought additional attention to the
subject of market liquidity. It is not my purpose, however, to opine on these very recent market moves
- a comprehensive understanding of which may depend on consequent market developments and the
fullness of time. I would only note that while premiums on riskier assets rose some last week, markets
are functioning well amid higher volatility, market discipline appears effective as investors are
reviewing their positions, and overall liquidity does not appear to be in short supply. The balance of my
remarks will focus on financial market liquidity from a somewhat broader and longer-term perspective.
In recent quarters, we witnessed very strong credit markets, bulging pipelines for leveraged loan and
high-yield bond issuance, and near-record low credit spreads. Structured fixed-income products
proliferated, and the investor universe expanded to match new supply. Global investment flows were
proven noteworthy for the lack of home-country bias. Managers of private pools of capital - in all of its
forms, private equity firms, alternative asset management companies, hedge funds, and investment
banks - increased funding from many sources and through many structures. Due in no small measure
to strong credit markets, leveraged transactions increased and the market for corporate control
became increasingly robust.
Fund managers of private pools of capital seized upon this opportunity to acquire more-permanent
sources of capital: extending lock-up periods; using retail platforms and co-investment funds to
increase 'stickiness' of contributed capital; securing greater financing flexibility from prime brokers;
accessing the private placement markets; and selling public shares of limited and general partnership
interests to new investors; to name just a few.
Key questions remain: Is liquidity at strong and sustainable levels, justified by economic
fundamentals? What is likely to be the liquidity trend going forward? In today's remarks, I will first
propose a definition of market liquidity based on what I believe is its most fundamental characteristic. I
will then discuss the primary sources of liquidity in the U.S. capital markets, and attempt to interpret
signals from financial asset prices in this environment. I will conclude by discussing implications for the
economy and policymakers.1
Liquidity: what is it?
The traditional concept of liquidity relates to trading: An asset's liquidity is defined by its ability to be
transformed into another asset without loss of value. This definition is sufficiently general to
encompass many ideas. Some assets, such as "money" are used to trade goods and services without
diminution in value, and therefore are highly liquid. Indeed, when different measures of the money
supply were established, it was with an eye toward determining the liquidity of the underlying assets;
as an example, components of M1 were considered more liquid than those in M2. It is in this sense
that some observers view the stock of money as a measure of liquidity, and changes in these
measures as roughly equivalent to changes in liquidity. I doubt, however, that traditional monetary
aggregates can adequately capture the form and structure of liquidity many observe in the financial
markets today. Instead, market observers are more likely to be referring to liquidity in broader terms,
incorporating notions of credit availability, fund flows, asset prices, and leverage.
As noted, 'liquidity' in the sense of "trading liquidity" reflects the ability to transact quickly without
exerting a material effect on prices. Liquidity is optimally achieved when myriad buyers and sellers are
ready and willing to trade. The trading is enhanced by market-makers and speculators alike.
Underlying this concept is that while buyers and sellers have different views on the most likely
outcomes - that is, after all what generates trading - they largely can agree on the distributions of
possible outcomes for which they demand risk-based compensation.
Consider liquidity, then, in terms of investor confidence. Liquidity exists when investors are confident in
their ability to transact and where risks are quantifiable. Moreover, liquidity exists when investors are
creditworthy. When considered in terms of confidence, liquidity conditions can be assessed through
the risk premiums on financial assets and the magnitude of capital flows. In general, high liquidity is
generally accompanied by low risk premiums. Investors' confidence in risk measures is greater when
the perceived quantity and variance of risks are low.
This view highlights both the risks and rewards of liquidity. The benefits of greater liquidity are
substantial, through higher asset prices and more efficient transfer of funds from savers to borrowers.
Historical episodes indicate, however, that markets can become far less liquid due to increases in
investor risk aversion and uncertainty. While policymakers and market participants know with certainty
that these episodes will occur, they must be humble in their ability to predict the timing, scope, and
duration of these periods of financial distress. Recall the market turmoil related to events in Asian
financial markets in 1997 and following the Russian bond default in the summer of 1998. Investors
flocked to "on-the-run" Treasuries, and risk spreads for high-yield corporate and emerging market
bonds spiked. Chairman Greenspan described these episodes as an apparent collapse in investors'
understanding of possible future risks, despite what appeared to be mild imbalances, which led to
"disengagement" by traders.2
Therefore, I wish to advance a simple proposition: Liquidity is confidence. That is, powerful liquidity in
the U.S. capital markets is evidenced when the economic outcomes are believed to be benign. When
the "tail" outcomes are either highly improbable or, at the very least, subject to reasonably precise
measurement, the conditions are ripe for liquidity to be plentiful. When fund flows are strong and
growing, there is little reason to expect trading positions to become inalienable. My goal in proffering
this proposition is to improve the discourse by reducing the different notions of liquidity to its most
fundamental feature. This exercise may also serve as a healthy reminder: If unmoored from
fundamentals, confidence can give way to complacency, complacency can undermine market
discipline and liquidity can falter unexpectedly. If, to the contrary, confidence is justified by real
economic determinants, liquidity can flourish.
Of course, some might disagree with this definition of liquidity. They may argue that any excess
liquidity in financial markets results from too little capital investment, here and abroad, which may arise
from a lack of confidence in future economic outcomes. For example, high cash balances at U.S.
corporations can be interpreted as indicating a lack of confidence in investment prospects. Previously,
however, I argued that while the build-up of cash since 2002 has been unusual, the most pressing
determinant was not uncertainty about the profit potential of capital investment.3 Instead, corporate
cash positions are explained more significantly by profits retained at foreign subsidiaries, and a
sharper focus by investors and ratings agencies on companies' abilities to finance short-term liabilities
internally.
Current sources of market liquidity
Let me discuss sources of liquidity of the U.S. financial markets. By my proposed definition, we must
ask what forces have increased liquidity (read: confidence) in the United States over the course of the
last couple of decades. I will turn, first, to two key drivers of liquidity: rapid financial innovation and
strong economic performance. A third important source of liquidity - resulting from the excess savings
of emerging-market economies and those with large commodity reserves - has also found its way to
the United States in pursuit of high risk-adjusted returns. We must judge the extent to which each of
these three liquidity drivers are structural or cyclical, more persistent or more temporary.
Understanding the sources of liquidity - and the causes thereof - should help inform judgments about
the level and direction of market liquidity. In so doing, we may better understand its implications for the
economy and policymakers alike.
First, liquidity is significantly higher than it would otherwise be due to the proliferation of financial
products and innovation by financial providers. This extraordinary growth itself is made possible by
remarkable improvements in risk-management techniques. Hewing to my proposed definition, we
could equally state that financial innovation has been made possible by high levels of confidence in
the strength and integrity of our financial infrastructure, markets, and laws. Moreover, remarkable
competition among commercial banks, securities firms, and other credit intermediaries have helped
expand access to - and lower the all-in-cost of - credit. Interest rate risk and credit risk exposures are
now more diversified.
Look no further than dramatic growth of the derivatives markets. In just the past four years, notional
amounts outstanding of interest rate swaps and options tripled, and outstanding credit default swaps
surged more than ten-fold. These products allow investors to hedge and unwind positions easily
without having to transact in cash markets, expanding the participant pool.
Syndication and securitization also lead to greater risk distribution. Commercial and industrial (C&I)
lending potential has expanded with the adoption of syndication practices, allowing credit risks to be
spread across a greater number of participating banks and nonbank lenders. Perhaps an even more
significant support for the expansion of C&I loans is the rapid growth of collateralized loan obligations
(CLOs) - special purpose entities that buy C&I loans with funds raised from investors seeking different
risk exposures. CLOs allow loans to be financed primarily with high-rated debt securities issued to
institutions like mutual funds, pension funds, and insurance companies. Indeed, in recent years, the
share of syndicated C&I term loans funded by institutional investors is estimated to have exceeded
that funded by commercial banks.
For CLO structures to be effective, they invariably must include a more risky equity tranche. Even the
most sophisticated financial products are not immune to the physical Law of Conservation of Matter -
the risk must rest somewhere. Hedge funds reportedly have served as willing buyers of these riskier
positions, and we are all aware of their phenomenal growth. Now, more than 4,000 hedge funds hold
assets of about $1-1/2 trillion. As important as the participation of hedge funds, the derivative products
themselves allow credit risk to be hedged, which has the beneficial effect of further increasing the pool
of other investors as well. The increase in financial product and provider innovation appears to be
quite persistent; future trends, however, are likely to be significantly influenced by legal, regulatory,
and other public policies.
The second factor, perhaps equally persistent, supporting strong investor confidence in U.S. markets
has been our economy's strong macroeconomic performance. Researchers have documented the
socalled "Great Moderation" in which the U.S. economy has achieved a marked reduction in the volatility
of both real gross domestic product (GDP) and core inflation over the past twenty years or so. In
theory, reduced volatility, if perceived to be persistent, can support higher asset valuations - and lower
risk premiums - as investors require less compensation for risks about expected growth and inflation.
In this manner, confidence appears to beget confidence, with recent history giving some measure of
plausibility to the notion that very bad macroeconomic outcomes can be avoided. The Great
Moderation, however, is neither a law of physics nor a guarantee of future outcomes. It is only a
description - an ex post explanation of a period of relative prosperity. If policymakers and market
participants presume it to be an entitlement, it will almost surely lose favor.
Let us look closer at the correlation between confidence and outcomes. Asset prices do appear
somewhat correlated with volatility associated with the real economy and inflation. For example, equity
valuations for U.S. corporations increased more in the past twenty years than in the two decades prior
to the Great Moderation. The price-earnings ratio for S&P 500 firms averaged 14 from 1960 to 1984
and rose to an average of 18 from 1985 to 2006. In addition, term premiums on long-term U.S.
Treasury securities are estimated to have declined substantially since the late 1980s.4 Moreover, this
decline is significantly associated with a reduction in uncertainty about long-run inflation and about
short-term interest rates.5
Third, liquidity in U.S. markets also increased significantly in recent years due to increased
international capital flows. These flows to the United States from global investors lead to higher
liquidity by increasing capital available for investment and facilitating greater transfer and insurability of
risk. A recent report by McKinsey & Company estimated that aggregate international capital flows
amounted to $6 trillion in 2005 - almost triple the volume a decade earlier - and that one-quarter of
the worldwide volume flowed through the United States.
Part of the increased international capital financial flows is a result of excess savings in some
emerging-market and oil-exporting countries relative to domestic investment - the phenomenon
Chairman Bernanke referred to as the "global saving glut."6 Rapidly aging populations in a few large
countries, such as China, Germany, and Japan, generated high savings. Also, some of the fastest
growing economies, especially in Asia, pursued export-driven growth strategies, thereby accumulating
large reserves of foreign-denominated assets. In addition, high prices of oil and other commodities in
recent years shifted income from importing nations to exporters, and research suggests that the bulk
of these "windfalls" has been saved rather than invested.7
On net, the savings of less developed countries has been deployed to purchase substantial volumes
of financial assets in markets in the most developed nations, most notably the United States and the
United Kingdom. Estimates from the International Monetary Fund indicate that the group of the most
advanced economies in the world swung from being net purchasers of foreign financial assets on the
order of $80 billion in 1997 to being net sellers of domestic financial assets to foreigners of about $570
billion in 2006.8
It is no accident that international excess capital flowed primarily to strong and stable economies and
those with highly-developed financial markets. In a world of funds increasingly without borders, we
would expect investors to seek out the best risk-adjusted returns. Sound, transparent regulatory and
legal frameworks in the United States, United Kingdom, and some other advanced economies have
helped contribute to the attractiveness of these markets. In addition, top-notch infrastructure allows for
efficient clearance and settlement procedures for transactions in the most sophisticated financial
markets, all of which promote investor confidence and continued sources of liquidity.
Implications for the economy and challenges for policymakers
Generally, high levels of liquidity offer substantial benefits to our financial system and overall economy
through higher financial asset prices and a more efficient means to channel funds between savers and
borrowers. Strong liquidity may also help to prevent imbalances in certain markets from spreading
because of the greater dispersion of risks.
The U.S. economy continues to demonstrate extraordinary resilience, no doubt supported by the
ability of financial markets to absorb substantial shocks. Financial markets have been buffeted by a
number of significant events, including a spate of corporate accounting scandals, the bond rating
downgrades of Ford Motor Co. and General Motors Corp. to speculative-grade status, the failure of
Refco, (at the time the largest broker on the Chicago Mercantile Exchange), and the imposition (and
5
An empirical link, however, between financial market volatility and output and inflation volatility is less established. Despite
the very low levels of S&P 500 return volatility in recent months, the averages over longer periods have not changed much -
volatility averaged close to 13 percent from 1985 to 2006 and between 1960 and 1984. One reason proposed for the lack of
a direct relationship is that asset price volatility depends not only on the volatility of future cash flows but also the volatility of
the discount rate that is applied to those cash flows, which does not appear to have declined in line with variation in
forecasts of cash flows.
6
Ben S. Bernanke, "The Global Saving Glut and the U.S. Current Account Deficit," Homer Jones Lecture, April 14, 2005, and
"Reflections on the Yield Curve and Monetary Policy," Economic Club of New York, March 20, 2006.
7
"Recycling Petrodollars," Matthew Higgins, Thomas Klitgaard, and Robert Lerman, Current Issues in Economics and
Finance, vol. 12, no. 9, Federal Reserve Bank of New York, December 2006.
8
These figures, as in table 1, refer to changes in current account balances for selected developed and emerging-market
economies based on recent estimates in the International Monetary Fund's World Economic Outlook (September 2006).
Except for a statistical discrepancy and a typically small capital account balance, a country's current account balance
approximates its financial account balance - the difference between domestic net purchases of foreign financial assets and
foreign net purchases of domestic financial assets.
BIS Review 21/2007
pullback) of capital controls in Thailand. But the effects on broader markets appear to have been
remarkably contained. Even the episode last year involving the hedge fund, Amaranth, which
accumulated losses of $6 billion in a few short weeks, seemingly had little impact beyond its direct
stakeholders.
It is hard to know with certainty when investors' confidence will be stirred - but not shaken - by these
events. It is harder still to know precisely why. I have argued that solid fundamentals - effective and
dynamic products and markets to disperse risk, stable economic performance, and robust and
attractive market infrastructures - are key underpinnings for strong liquidity and correspondingly
strong investor confidence. Surely, policymakers must be vigilant to maintain output stability and low
and anchored inflation expectations. In addition, policymakers need to encourage sound risk
management by private participants as the first line of defense against financial instability. In
particular, we should promote policies that encourage stakeholders to engage in ex ante practices,
protocols, and principles - including those recently set forth by the President's Working Group on
Financial Markets - to accomplish that objective.
Of course, investor confidence and liquidity can shift. In the aftermath of a financial shock, if buyers
and sellers of credit can no longer agree on the distribution of possible outcomes, their ability to price
transactions will be severely limited. While we cannot - and often should not - prevent all shocks or
predict how they will reverberate through the financial system, we can attempt to create conditions that
would lead investors to most quickly rebuild their confidence. That is most likely to occur when
underlying fundamentals are solid.
Monetary policy is no less challenged by the level and prospects for liquidity. We policymakers must
ask whether liquidity conditions are obscuring signals from financial asset prices that we would
otherwise use to gauge the performance of the real economy.9 Liquidity conditions could, in theory,
lead to lower-than-justified risk premiums that stimulate aggregate demand or otherwise generate
excessive inflationary pressures. Of course, inferences from market prices are always imprecise,
because prices depend on expected growth, the variation surrounding that expected path, and
investor risk aversion, none of which we can precisely observe. Market liquidity may further confound
the inference challenges. Allow me to comment, nonetheless, on a few key indicators.
Look at the current configuration of Treasury yields across the maturity spectrum. Typically, investors
require compensation for the greater exposure to interest rate risk from holding longer-term securities,
leading to an upward-sloping yield curve. Since about mid-2006, the yield curve has been about flat to
downward-sloping. Currently, the two-year rate slightly exceeds the ten-year Treasury rate, which
stands just above 4-1/2 percent. A negatively sloped yield curve has, in the past, served as a
reasonably good predictor of economic recessions.
But, there are compelling reasons to suspect that level of liquidity is affecting the slope of the yield
curve, and lessening its predictive power. The same factors that are contributing to liquidity - low
uncertainty about inflation and output - are also driving down term premiums and, hence, long-term
Treasury yields. Thus, to the extent that low long-term Treasury yields and the negative slope of the
yield curve reflects a lower term premium, rather than a lower expected short rate, it is less likely to
signal future economic weakness.
High liquidity could also obscure some information we glean from corporate bond prices. What if the
current level of liquidity caused lower risk premiums than could be justified by actual credit risks?
Might a misallocation of resources result? Many commentators have pointed to the low spread of
corporate yields relative to Treasuries as a sign of investors "reaching for yield" due to perceived
excess liquidity. Risk spreads, however, appear less exceptional given the remarkable strength of the
corporate sector. We can decompose risk spreads for corporate bonds into a series of forward
spreads over a sequence of time periods. Forward spreads include compensation investors require for
expected credit losses and a risk premium, and it would be reasonable to expect that investors would
have a stronger conviction about expected credit losses in the near term than at future horizons.
Currently, forward risk spreads one to two years ahead are quite low by historical standards,
consistent with very liquid balance sheets, multi-decade low leverage ratios, and robust profitability. In
sharp contrast, one-year forward risk spreads five or ten years ahead are higher relative to their
averages of the previous ten years. I take some comfort from these implied forward spreads to
suggest that investors may not be unduly sanguine about potential credit losses beyond the
nearterm.10 Of course, too much precision cannot be put on assessments of risk premiums. This is an area
worthy of continued analysis.
Some market participants tell me that the very low bond default rates seen recently, realized and
expected, are themselves a reflection of liquidity. That is, excess market liquidity may have allowed
less than creditworthy firms to refinance their obligations, thereby only deferring their financial
difficulties. Other observers note the rise in the second half of last year in the share of new bond
issuance that is rated highly speculative, and an increase in purchase and debt-multiples for leveraged
buy-outs, suggesting some pick-up in risk-taking that may be indicative of overconfidence. This
possibility cannot be ruled out. Others have pointed to the low levels of stock market volatility in recent
months (prior to last week) as indicative of pressures from excess liquidity. Naturally, one would
expect that high levels of liquidity would lead to lower volatility as investors quickly force asset prices
back to their fundamental values. But, recent levels are not unprecedented; they were equally low
during much of the 1960s. And, of course, volatility itself can be volatile. There may be good
fundamental reasons for risk and risk premiums to be relatively low and for liquidity and confidence to
be reasonably strong. Even so, the pace of change in the capital markets by credit buyers and sellers
reminds us to constantly revisit assumptions underlying the financial and economic environment.
If liquidity conditions and risk premiums of the last several quarters were the sole basis by which to
judge the stance of monetary policy, it would be hard to conclude that monetary policy has been
restrictive. Of course, the assessment of the stance of monetary policy also depends on a variety of
other important factors.
Conclusion
In summary, liquidity has risen significantly, with important benefits to our financial system and
economy. An important source of strength has been financial innovation, and while we have yet to see
how some new products will play out in a more stressful environment, there almost certainly will
remain a greater dispersion and insurability of risks. Stable output and price stability have also been
important contributors to liquidity and investor confidence by helping to anchor views about
longerterm economic outcomes. And solid fundamentals may help to ease any changes in liquidity should
they occur. Hence, job number one for the Federal Open Market Committee is to choose a course for
policy to best keep the macroeconomy on an even keel. This attention to our dual mandate - to
maintain stable prices and maximum sustainable employment - supports investor confidence in the
economy and the considerable benefits conferred by liquidity.
Table 1. Current account balances, 1997 and 2006
(billions of U.S. dollars)
p p
1997 2006 Change
1. Advanced economies 81 -571 -652
2. United States -136 -869 -733
3. United Kingdom -2 -56 -54
4. Australia -13 -41 -28
5. France 40 -39 -79
6. Italy 32 -26 -58
7. Spain 3 -101 -104
8. Other Euro area 24 156 132
9. Japan 97 167 70
10. Other advanced economies 36 238 202
11. Other emerging market and developing countries -85 587 672
12. Developing Asia 10 185 175
13 Latin America and South America -67 35 102
14. Middle East and Africa 2 315 313
15. Central and Eastern Europe -29 52 81
16. Statistical discrepancy (line 1 plus 11) -4 16 20
p projection by the International Monetary Fund
Note: Components may not sum to totals because of rounding error.
Source: World Economic Outlook, International Monetary Fund, September 2006. Data for advanced economies come from
table 26 in the statistical appendix; data for other emerging market and developing countries come from table 28.
BIS Review 21/2007