2 - Liquidity and monetary policy

Summary

Introduction

In the period leading up to the financial crisis of 2007–8, financial institutions of all sorts increased their leverage in the wholesale markets, relying heavily on collateralised borrowing in the form of repurchase agreements (‘repos’) and issuance of asset-backed commercial paper (ABCP). As the crisis approached, lenders became nervous and significantly shortened the maturity of the loans they were prepared to make. When the crisis hit, the disappearance of short-term funding created severe problems for many financial institutions. Some large firms failed and further failures were prevented only by the intervention of the central banks.

Although the origin of the crisis may have been the US sub-prime mortgage market, the early stages looked like a crisis of liquidity provision. At the end of July 2007, two Bear Stearns funds filed for bankruptcy and a third suspended redemptions. More bad news followed and then, on 7 August, BNP Paribas halted redemptions from three investment funds because it could not ‘fairly’ calculate their net asset value (NAV). Potential investors, mainly money market mutual funds (MMF), declined to roll over their purchases of ABCP. Since many of the vehicles that comprised the parallel banking system (PBS) were sponsored by banks and/or had liquidity guarantees from banks, there was a fear that these assets would end up on bank balance sheets. This in turn raised concerns about counterparty risk among the banks and caused LIBOR to shoot upwards. The European central bank was forced to inject €95 billion in overnight lending into the market in order to cope with the demand for liquidity (Acharya et al., 2010).