Behavioral finance FAQ / Glossary (Liquidity)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Liquidity

08/9i, 09/3i + see (liquidity)
premium, squeeze, trap

Liquidity means enough stuff on market stalls
and enough cash in the hands.

Are you prepared for wintery days
when nobody brings stuff or money?

Definition I (market liquidity)

The market liquidity is the presence of

counterparts for transactions.

Practically, it is:

The possibility, at any moment, for buyers to find sellers, and
   and for sellers to
find buyers, without too large price

disruptions.

Hide and seek, but not as a game!

The availability of goods, assets to be bought and of money to buy them.


Definition II (bank and monetary liquidity)

The solvency and liquidity of a bank
is its availability of financial resources.

It is the capacity for that bank to have in its pockets, oops, balance sheet:

(Solvency) Enough stable funds (from depositors and from 

other financial institutions) to finance its loans and other assets,

(Liquidity) Enough immediately available money (cash, accounts

in other banks...)  to face potential customers withdrawals and transfers


If most banks get illiquid
, and do not trust one another to make cross loans /
deposits to palliate this lack of available resources, here comes a general (also
called "systemic") lack of monetary liquidity.


Effects of liquidity ...or of a lack of it

Making things smooth or rough.


Various structural factors as well as behavioral factors (see the related
section) play in supplying liquidity for the economy in general or for specific
sectors.

Those factors can:

Either

favor
liquidity.

 

 

 


Theoreticians consider that enough liquidity in a market,

* either in the amount of money available,

* or in the quantity of goods or assets  available

contributes to market efficiency.
See liquidity premium.

Or

hinder
liquidity


When funds dry up, a liquidity crisis
(
illiquidity) strikes.
See liquidity squeeze, liquidity trap.

The 2007-2009 subprime crisis was a mammoth
example.

Or create

excess
liquidity

 



This characterizes the opposite imbalance
(bubbles, inflation...).

Overliquidity on the buy-side can be seen also as
lack of liquidity on the sell side if we refer to the
above definitions (not enough counterparts in goods
and assets offered to "mop up" the money offered).


What are those liquidity factors?

The right pipes and the right water.


We will not develop here a theory of markets, but let us say that
various factors
affect market liquidity:

Structural or economic factors.

As an examples, a dispersion of players and a large market tend to
make that market
more liquid and less volatile.

A loose monetary policy does it also, but in a less sustainable way

Many behavioral factors.

Let us cite mimicry / herding. It makes nearly everybody
try to buy or sell at the same time, a sudden greed / panic contamination
that endangers liquidity.

(Flight to) Liquidity

See liquidity squeeze

(Il-)liquidity / Liquidity crisis

08/i + see liquidity squeeze

Liquidity premium

00/10i,12i - 01/1i
+ see liquidity trap

If the thing can easily be resold at any time,
it deserves a higher price when buying it, no?

In fact, there are two different notions.


1) In economics
, the liquidity premium means that

     long term interest rates are usually higher than
   shorter
ones.

People normally accept to be paid less interests for money they lend or
deposit if they can get it back soon and without loss.


2) In asset markets
,
the liquidity premium is a higher price in average

for assets with a large market.

Those assets have the double advantage:

To be accessible more easily by large investors than assets with
    narrow market,

To entail little risk - even for those large players - not to find

counterparts in the future, except by accepting a "haircut" (huge
price  rebate), when they will want or need to sell them (see
liquidity squeeze).


Thanks to those attractive features, accessibility and availability, investors
tend to give more value to those assets. They are thus priced at a premium.

On the other hand, even if it seems contradictory, a rarity /
scarcity premium
can also exist, for scarce assets that many investors
try to acquire (see funnel effect).

 

Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Liquidity squeeze

00/10i,12i - 01/1i - 07/8i
+ see funnel, bubble, crash

A liquid market is not one that takes water,
but one that "fluctuat nec mergitur"

(floats but does not drown
, the motto of Paris).

Liquidity squeeze in banking,
     and its economic consequences

Is the bank cistern dry?

A general bank liquidity squeeze (inability for banks to fund customers
and to face withdrawals) happens when:

Central banks take steps to reduce the money   quantity
   available
,
usually in order to fight inflation, by deterring borrowing.



Or commercial banks become wary to make loans, either to
   customers
(credit crunch) or between one another (near
   disappearance
of the interbank market).

In 2007, a worldwide interbank liquidity squeeze, and a
general credit crunch stroke as a consequence of the
"subprime crisis".

Central banks had to inject massive liquidity in the banking system to
avoid a "systemic" crisis (= a domino effect sending most banks into
a bankrupt situation).

A related phenomenon, here is the behavioral aspect, is a
bank run when a mass of depositors,
afraid that their bank does not have or cannot find all the cash
needed to refund all of them, queue at the cashier-desk to recover
their money before the tank gets dry.

From a bank crisis to an economic crisis

A bank liquidity squeeze can become an illiquidity / liquidity crisis,
with crucial economic
effects, as a credit crunch and lack
of cash deprive the economic lungs of oxygen.

It might combine with a asset market illiquidity, as a full systemic
crisis (see below)

Liquidity squeeze in asset markets,
     and its economic consequences

Those assets suddenly stink, give me the cash.

In asset markets a liquidity squeeze (illiquidity)
is a sudden lack of asset buyers.
Sellers do not find counterparts.

This can come from a lack of cash, as seen above, but more often there
are behavioral causes
.

It can arise, even in usually large markets, that all investors rush and try to
sell at the same time (flight-to-liquidity)
and nobody feels ready to buy,
except at much lower prices.

From an asset market crisis to an economic crisis

A fit of illiquidity that hits large sectors of a market is a "rare
event"
(see that phrase)
as it happens only in exceptional
circumstances,

But it can have a dramatic importance.

If a sudden illiquidity is not quickly corrected, it can 
end in a full (systemic) financial crisis / crash.

Probability-based models (see model), that takes into account
only ordinary (measurable) risk, usually skip the (not measurable)
uncertainty
of an unforeseen liquidity crisis.

From the buying binge to a bubble

Inversely, there can be an upward "funnel effect"

when too many people with too much money
chase too scarce assets.

Then, an equilibrium price, which would allow transactions to be made,
can not be reached in a stable enough basis.

This opens the road to inflation and / or bubbles.

Liquidity trap

 

If the donkey doesn't feel like drinking,
to bring it more water will not convince it.

Definitions:

In economics, a liquidity trap occurs when people are
reluctant to spend or invest
their money.

They prefer to hoard it, however abundant the available liquidity is and
whatever the central banksdoes to  lower interest rates.

As a result the economy stays depressed or stagnant.

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