Systemic Liquidity Risk and Bipolar Markets: Wealth Management in Today's Macro Risk On/Risk Off Financial Environment

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Liquidity and Maturity Transformation

In this chapter we will explore the fundamental and important inter-dependence of market liquidity and maturity transformation. The procedures and legal framework that have been developed within global money markets to facilitate the spanning of funding intervals which can be very short, i.e. overnight, to very long term, and which enable maturity transformations, are indispensable to the smooth functioning of the private sector banks and the integrity of the entire credit system. Later in the discussion there will be a more robust explanation of maturity transformation but an initial outline will be useful now.

William Dudley, the President and Chief Executive Officer of the Federal Reserve Bank of New York, gave an influential speech in November 2009 in which he addressed the problems within global money markets, particularly centered on those in the US, which had arisen at the height of the financial crisis, and most acutely following the collapse of Lehman Brothers. He provided the following useful starting point for our discussion of systemic liquidity and maturity transformation: [1]

The need for maturity transformation arises from the fact that the preferred habitat of borrowers tends toward longer-term maturities used to finance long-lived assets such as a house or a manufacturing plant, compared with the preferred habitat of investors, who generally have a preference to be able to access their funds quickly. Financial intermediaries ...