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As conventional wisdom has it, markets shut down during financial crises, as sellers struggle to find their buyers. However, an empirical assessment of what really goes on with secondary market liquidity in periods of financial distress is far from trivial, as a quick survey of the related literature illustrates. Whereas the relation between liquidity and market returns in the US has been studied extensively in both directions, the results differ according to the measure of liquidity in use. Moreover, much less is known about the behavior of secondary market liquidity (in its different dimensions) in periods of financial turmoil, a critical test to evaluate both the functioning of financial markets and the mechanics of financial crises. This paper contributes to fill in this gap, conducting the first systematic empirical study of secondary market liquidity under stress across emerging market crises.
A generally accepted theoretical argument relating liquidity and market returns is the collateral-based view: pronounced falls in asset prices reduce the value of financial intermediaries’ capital and increase their margin calls, forcing them to liquidate their positions, thereby inducing wider bid-ask spreads and increasing the price response to trading. Since net withdrawals are a function of the intermediaries’ performance, when the value of assets drop the short-term inflow of funds decreases or even reverses, forcing financial intermediaries to sell, adding to the price downturn, and generating a spiraling fall in some liquidity measures. Therefore, market liquidity is closely related to intermediaries’ funding needs, and this mutually reinforcing relation can generate sudden spikes in illiquidity indicators. While collateral-based theories assume that outside capital does not enter the market during downturns, fire-sale theories highlight precisely the role of outside capital: lower asset prices reward liquid outside buyers who profit from illiquid asset holders. Fire-sales (namely, forced wide-spread selling from distressed funds when investors redeem their capital en masse) put downward pressure on prices, as outside buyers demand additional compensation for providing needed liquidity.
The rising trend in grain prices has stoked fears of food price inflation because of the forward connections of grains with many food items, ranging from meat and eggs to sweets and chocolates, to cereals and pasta. Financial analysts have attributed the hikes in grain prices to increases in the demand for ethanol. These analysts have questioned the prevailing view that the culprits underlying the rising trend in grain prices are carnivores in countries like China and India, droughts in Russia and Eastern Europe, or heavy rain in North America. Instead, they view the real culprits to be increases in the consumption of ethanol and other bio-fuels which, through the derived demand, have led to increases in prices of these goods. Some researchers view the use of commodities by financial investors (the so-called “financialization of commodities”) as partly responsible for the recent price spike (Baffes and Haniotis, 2010).
Economic and regulatory capital are two terms frequently used in the analysis of the new framework for bank capital regulation proposed by the Basel Committee on Banking Supervision (2004), known as Basel II. In particular, many discussions have highlighted the objective of bringing regulatory capital closer to economic capital. For example, Gordyand How ells (2006, p. 396) state that "the primary objective under Pillar 1 (of Basel II) is better alignment of regulatory capital requirements with economic capital demanded by investors and counterparties."
