Understanding Basel III, What Is Different After January 2015

Understanding Basel III, What Is Different After January 2015

According to Claudio Borio, (Monetary and Economic Department, BIS), a liquidity crisis is defined as a sudden and prolonged evaporation of both market and funding liquidity, with potentially serious consequences for the stability of the financial system and the real economy. <br /> <br />Market liquidity is defined as the ability to trade an asset or financial instrument at short notice with little impact on its price. <br /> <br />Funding liquidity is defined more loosely, as the ability to raise cash (or cash equivalents) either via the sale of an asset or by borrowing. <br /> <br />I like the way Claudio describes it: Liquidity crises are not like meteorite strikes; rather, they are the endogenous result of the build-up in risk-taking and associated overextension in balance-sheets over a prolonged period – what might be termed the build-up of financial imbalances. <br /> <br />Unmistakable signs of such imbalances are the growth of (overt and hidden) leverage; unusually low risk premia and volatilities, and buoyant asset prices. <br /> <br />A corollary is that the build-up to the crisis is characterised by “artificial liquidity”. There is a self-reinforcing process between liquidity and risk-taking. <br /> <br />The easing of funding liquidity constraints during the expansion phase supports greater risk-taking, by facilitating position taking and an increase in exposures. <br /> <br />This improves market liquidity and boosts asset prices. <br /> <br />As a result, volatility and risk premia fall, in turn inducing a further relaxation of funding liquidity constraints. <br /> <br />When this mutually reinforcing process goes too far, it results in overextensions in balance sheets and it sows the seeds of its own destruction. <br /> <br />Today we will start with liquidity.