Measuring and Managing Liquidity Risk

1

Banks as lemons?

1.1 INTRODUCTION

It was a sunny and warm Thursday of midsummer. Some dark clouds in the previous days suggested that sudden showers had been expected to fall in the short term, but no one would have forecast the magnitude of the incoming financial tsunami.

But, citing L. McDonald [87], Wall Street's most sinister troubles occasionally arrive without the thunder of the guns and the clash of mounted cavalry on the trading floor. Some deadly problems come creeping in unannounced and often unnoticed, when financial players unobtrusively arrive at a single conclusion at around the same time. No one can say anything about collective changes: suddenly there is a lightning bolt of fear crackling through the market, and the consequences are there.

That day was August 9, 2007. Some years later, that day be referred to as the dawn of the worst crisis to hit financial markets in the last two decades. It begun with newswires reporting the announcement by some BNP Paribas funds to freeze redemptions, citing difficulties in valuing their assets due to the lack of liquidity in subprime mortgage markets. In a few hours the international money market had been seriously deadlocked: central banks had to inject an enormous and unprecedented amount of liquidity into the system to settle its daily payment obligations (e.g., the special refinancing operation conducted by the ECB with overnight maturity registered a request record for EUR95 billion; on the same day the Fed injected ...