SERIOUS MONEY A better evaluation of liquidity positions and how they change over time is needed, writes David Clarke

THE CURRENT financial crisis has revolved around the drying up of markets that had been built on the presumption of ample liquidity.

Massive leveraged positions were built up in instruments that, in spite of their triple-A credit ratings, suffered from significant systemic liquidity risk and were difficult to value in the best of times.

Current regulatory solutions focus on the liquidity position of institutions. But if liquidity positions are to be properly evaluated, there needs to be better evaluation of the liquidity of instruments and how they change over time.

Does this mean that we need a formalised liquidity rating system along the lines of the existing less-than-satisfactory credit rating system? Perhaps not, but we do need to better understand the drivers of liquidity and its pricing. Investor mandates need to include liquidity factors and independent and bank research departments need to rate instruments.

Liquidity risk is a difficult concept to grasp and is often confused with credit risk. One simple way of distinguishing the two is as follows.

Credit risk is the probability that a counterparty will be unable to repay money due. Liquidity risk relates to a lender's future requirements to generate cash to meet its own obligations. A liquidity crisis, where lenders sell securities to meet their own cash requirements, will almost inevitably lead to a credit crisis as investors sell bonds because they are worried about the issuers' ability to repay. Similarly, a credit crisis will lead to a liquidity crisis, but the causality differs.

During the crisis, some central banks have moved quickly to expand the range of instruments against which they lend money.

It seems probable that central banks will continue to lend against non-government collateral in the future, as the ECB has done in the past. Varying eligibility criteria and haircuts (the percentage of a security they will advance) would give central banks an enhanced range of instruments to manage market liquidity.

The Institute of International Finance has proposed to explore alternative valuation techniques for assets in illiquid markets when market prices are clearly not reflective of fair, willing seller/ willing buyer, valuations - ie where liquidity dries up.

A liquidity rating could provide an objective measure of this as well as helping to determine, in the first place, whether instruments should be held in the banking book or the trading book.

The following are some of the factors that contribute to the liquidity of an instrument: central bank repo eligibility and haircuts; issue size; time since issuance; market maker support; price volatility; complexity of structure, availability of comparable benchmarks and breadth of the investor community.

There are many more factors, and these vary in their influence over time. Some research has been carried out into this, but not comprehensively and not consistently. Despite its complexity, it is important to evaluate how liquidity is likely to respond to conditions of systemic stress.

An understanding of liquidity drivers will also encourage virtuous behaviour by issuers, dealers and investors. Issuers will resist dealer pressure to create small, complex, idiosyncratic structures unless there is a clear investor benefit. Issuers will be more likely to reward dealers who maintain liquidity and transparency in their issues as this will have an impact on their issuance costs.

Geared institutions and those who lend to them will be able to make better informed decisions about the liquidity of instruments held. This will also assist regulators in their prudential supervision of insurance companies, banks and bank lending to hedge funds.

Above all, a greater focus on liquidity of instruments will help to avoid a build-up of aggregate market positions in highly illiquid instruments by geared institutions at times of easy market liquidity. - ( Financial Times service)

The writer is former head of funding at the European Investment Bank and a consultant to the International Capital Markets Association. He is writing in a personal capacity