Liquidity and Leverage

One of the most important aspects of the subprime crisis was the sudden reluctance of financial institutions to lend money, and the increased reluctance to borrow on the part of financial as well as nonfinancial businesses and households, a development called “The Great Deleveraging.” It contributed to the rapid decline in the market prices of risky assets and was self-perpetuating. In this chapter, we try to disentangle the concepts of liquidity and leverage. We give definitions of each, showing how they are related, and, in Chapter 14, explain their role in financial crises.

The term “liquidity” has been defined in myriad ways that ultimately boil down to two properties, transactions liquidity, a property of assets or markets, and funding liquidity, which is more closely related to creditworthiness. Transaction liquidity is the property of an asset being easy to exchange for other assets. Most financial institutions are heavily leveraged; that is, they borrow heavily to finance their assets, compared to the typical nonfinancial firm. Funding liquidity is the ability to finance assets continuously at an acceptable borrowing rate. For financial firms, many of those assets include short positions and derivatives.

As with “liquidity,” the term “liquidity risk” is used to describe several distinct but related phenomena:

Transaction liquidity risk is the risk of moving the price of an asset adversely in the act of buying or selling it. Transaction ...

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