Market liquidity and stress: selected issues and policy implications

Claudio Borio

BIS Quarterly Review, 2000

Abstract: Since turbulence engulfed financial markets in mature economies in autumn 1998, market liquidity has attracted increasing attention on the part of market participants, central banks and regulatory and supervisory authorities. In particular, perceptions of a persistent reduction in market liquidity in a number of segments of global financial markets have raised questions about their potential vulnerability to financial disturbances. The purpose of this note is to explore some of the issues raised by these developments. The first section defines two closely related notions of liquidity, namely market and cash liquidity. The second explains the reasons for the growing interest in market liquidity. The third draws some lessons about the determinants of market liquidity from past episodes of market turmoil. It argues that for a proper understanding of liquidity under severe stress, the interaction of basic order imbalances with cash liquidity constraints and counterparty risk needs to be explained. Leverage and risk management play a key role. It also suggests that some factors that may contribute to liquidity in normal times can actually make it more vulnerable under stress. The final section considers some policy implications.

Date: 2000
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