Speaking broadly liquidity include different dimensions of the economy including credit flow to leverage economic expansion, the ease with which market participants can transact, also large amount of buying and selling without much change in the prices. Today we review liquidity relative to financial markets.
Liquidity plays an important role in the functioning of financial and capital markets and considered to be the lifeblood of the financial markets. Blue chip stocks and money market instruments are the assets that easily attract great amount of liquidity.
From the beginning of the last year (2007) till now, world economy witnessed the period of reversed polarity in liquidity.
Started with more and more funds attracted towards financial markets’ where funds have been raised through the direct issuance of securities to investors. The process caused wider expansion in the global capital markets. Liquidity has considered exceptional during the initial months of calendar year’07. Financial institutions other than traditional banks, aggressively led the piles of fund to the expanded financial markets and has started to play the most active role in the provision of credit and liquidity, the act later back fired and silently laid down the gravestone for them and also considered as the one of the primary reasons for the current troubled economic conditions.
Coming back to the initial period of extra ordinary liquidity, which has been supported by liberal credit system and triggered the voices of so called’ new financial innovation. Credit facilities have leveraged beyond the practices of risk management. Institutions manage to overcome the credit risks in their trading-related exposure by collateral or margin. The financial liberalization without much regulations and the overconfidence to earn whopping profits has indirectly boosted up the high-risk speculation activities of the big financial houses.
Speculation activities and the prevailing greed have attracted more and more liquidity in financial markets and the bold borrowing pattern appeared among market participants that over shadow the fears of highly vulnerable risks of credit defaults.
The liquidity itself is not easy to measure, only the growth patterns can be evaluated from the indicators used to measure funding for liquidity like sum of credit flows, monitory growth in aggregate financial assets, forms of borrowing, turnover volumes and change in assets prices. That’s the way growing liquidity can be studied from those indicators but liquidity cannot measure in specific terms. It becomes even more complicated when none of the measures provide a reliable way of judging how vulnerable markets or liquidity are to a reversal of either liquidity conditions or market conditions, and the scale of damage that might accompanies a reversal.
The fears turned into reality with sub prime mortgage crisis, that has shrunken liquidity in the global financial markets due to failure of investment companies, mortgage firms and other institutions those spread their exposure to credit system beyond the limits of the risk management practices. Fall in housing sector has left the collateral with no buyer and extremely low financial value in comparison to earlier expectations, when the credit has been raised against them. The ongoing financial crisis made some of the big financial houses go bankrupt and cease their existence.
The present situation of credit crunch and scarcity of liquidity have outgrown the wildest expectations, despite the efforts of the central banks world wide by pumping lots of liquidity in economy, that also does not seem enough. Usually the mechanisms of the Central banks have built around a range of instruments they can be used in the event of a crisis. By injecting liquidity into the system, and thus strengthening confidence in the system, 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.
Finally the conclusion is’ Whenever ample liquidity exists in the financial markets, this can be watch over through things we can measure, like aggregate financial assets and credit flows, And when liquidity falls back, the effect is observable with market prices and volumes. But we do not have, and probably never will have, a set of indicators that offer the promise of perfect predicting when liquidity conditions will reverse, or when markets are particularly vulnerable to a more decline in liquidity.
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Financial Markets and Liquidity Liquidity financial system economy borrowing crisis risk management
