Liquidity Shortage Research Articles

The Impact of Financial Innovations on the Amplification of Financial Crises

A financial crisis arises when the value of financial assets or markets rapidly declines, often leading to panic, liquidity shortages, and the collapse of the banking systems. In modern financial systems, financial innovations such as mortgage-backed securities (MBS), credit default swaps (CDS), and high-frequency trading have emerged as key drivers of both market efficiency and systemic instability. These innovations can amplify financial crises by increasing leverage, introducing complexity, and precipitating abrupt market shocks. This paper examines how specific financial innovations, particularly derivatives like MBS and CDS, contributed to the amplification of the 2007-2008 financial crisis. The study uses a case study approach to analyze the crisis and evaluate both the advantages and disadvantages associated with these financial innovations. The conclusion underscores the necessity for stronger regulation and oversight of financial innovations since unchecked complexity, excessive leverage, and inadequate risk management can precipitate to systemic collapse. Transparent markets, robust risk management practices, and prudent regulation are indispensable in averting and preventing future crises. This research highlights the critical role that financial innovations play in both driving and mitigating financial crises. By analyzing the 2007-2008 American Financial Crisis, the paper provides insights into how these innovations, while offering potential benefits, can also introduce significant risks when improperly regulated. The findings emphasize the necessity of balanced oversight to ensure innovation does not compromise systemic stability.

Loans for the “Little Fellow”: Credit, Crisis, and Recovery in the Great Depression

This paper identifies how bank branching benefited local economies during the Great Depression. Using archival data and narrative evidence, I show how Bank of America’s branch network in 1930s California created an internal capital market that diversified away local liquidity shortfalls, allowing the bank to maintain 49 percent higher credit growth from 1929 to 1933 than competing banks. The bank’s presence mitigated cites’ property value contractions and strengthened their recovery through 1940. Linked individual data show that the bank’s proximity to workers hastened the transition from agricultural employment to human-capital–intensive sectors in the 1930s, generating structural change and higher wages. (JEL E32, G01, G21, N12, N22, N92, R23)

Can Outsiders Often See the Most? Evidence from China: The Impact of Foreign Investors on Insider Trading

ABSTRACT Insiders could exploit their informational advantage to obtain excessive returns. Based on the quasi-natural experiment of the Shanghai-Hong Kong and Shenzhen-Hong Kong Stock Connect trading systems, we examine the inhibitory impact of foreign investors on insiders’ informational advantage. Our findings indicate that the advent of the Stock Connect trading system has diminished the profitability of insider trading for the target companies. The influence operates through two primary channels: the information effect and the liquidity effect. Specifically, the Stock Connect trading system has hindered insiders’ stock buying and their profitability by reducing stock price synchronicity. Besides, it facilitates an increase in insiders’ stock selling by addressing liquidity shortages. Further tests demonstrate that those insiders with obvious informational advantage and great power are obviously impacted by the inhibition effect on their profitability. Our results show that the exploration of investment opportunities by foreign investors has reduced the insiders’ ability to profit from increasing their shareholdings. Additionally, it offers liquidity support for insiders, enabling them to decrease their shareholdings. These promote fair trading and the efficient functioning of the capital market.

Do banks adjust their capital when they face liquidity shortages? Evidence from U.S. commercial banks

AbstractWe investigate how small and large banks behave when they face liquidity shortages. Our findings reveal that only small banks increase their capital ratios during episodes of liquidity shortages. They do so by downsizing but also by holding less risky assets and by reducing their lending. Furthermore, the increase in capital ratios is higher for small banks which are more reliant on market liquidity and small banks operating below their target capital ratio. On the whole, our findings show that small banks operate prudently whereas large banks are less concerned. Our work has strong implications for bank regulation and supervision.

Does Financial Derivative Hedging Reduce Firms’ Financial Constraints?

This study examines the relationship between the firms’ derivative risk management and its financial constraints. Firms face a wedge between their internal and external financing for their investments. I test whether this wedge reduces firms’ financial constraints when they hedge using interest rate, foreign currency, and commodity derivatives. Using an event study and a difference-in-differences framework around implementing Financial Accounting Standard (FAS) 123R, this study shows a strong causal relationship between derivative hedging and financial constraints. I find that net debt increases for the derivative hedging firms, on the other hand, cash holdings and net equity issuance decreases. When managers of non-financial corporations believe that their firm will face a liquidity shortage, they save more cash out of cash flow as a precautionary measure. Both cash flow-cash sensitivity and investment-cash flow sensitivity decrease. The analysis also shows that both the loan spread and the probability of covenant violation decrease after firms start derivative hedging. The main implication of the analysis is that risk management influences the asymmetric information between lenders and borrowers: the increase in risk management, the less the asymmetry.

Impact of Off-Balance-Sheet Activities on the Effectiveness of Monetary Policy

Off-balance-sheet (OBS) activities are special means of credit expansion of commercial banks, which can affect banks’ assets allocation decisions, loans supplies, and the bank lending channel of monetary policy transmission. This paper analyses the impact of OBS activities on banks’ asset allocation and on the effectiveness of monetary policy. Our findings show that increases in OBS activities weaken the effectiveness of price-based monetary policy through the bank lending channel, and this dampening effect is stronger in periods of market liquidity shortage.

Bank’s strategic interaction, adverse price dynamics and systemic liquidity risk

AbstractWhen a widespread funding shock hits the banking system, banks may engage in strategic behaviour to deal with funding shortages by a pre-emptive disposal of assets. Alternatively, they may adopt a more cautious strategy to mitigate price reactions, thereby distributing the assets sales into smaller portions over time. We model banks’ optimal behaviour using standard optimisation techniques and show that an equilibrium always exits in a stylised setting. A numerical analysis to approximate the equilibrium supplements the theoretical part. The implementation delivers two liquidity measures for the German banking system: the Systemic Liquidity Buffer and the Systemic Liquidity Shortfall. These measures are more informative about systemic liquidity risk than regulatory liquidity measures, such as the LCR, because they model adverse, nonlinear price dynamics in a more realistic way. Our approach is applied to different stress scenarios.

Economic impact of a credit guarantee scheme: evidence from Spain

ABSTRACT Credit guarantee schemes have emerged as one of the preferred choices for policy makers concerned about financing small and medium-sized enterprises (SMEs). This article assesses the economic impact of a credit guarantee scheme by using data from a Spanish regional guarantee company for the years 2019 and 2020. We employ an input–output (IO) model, which is a robust methodology that has not been previously used in this type of study. Our findings confirm that a credit guarantee scheme has a positive impact on economic growth, as evidenced by increases in output, gross domestic product (GDP), and employment. We also evaluate the support measures implemented by the regional government to reduce the liquidity shortfalls experienced by SMEs during the COVID-19 pandemic, corroborating that during crises, government financial support policies to guarantee systems yield positive macroeconomic effects in the region in which they are implemented.

Asset bubbles, financial crisis and countercyclical policies

In this manuscript, we examine the causes of asset price bubbles and financial crises as well as the current challenges facing the regulatory framework of the financial system. We argue that the current model of regulations cannot stop the inevitability of either asset bubbles or financial crises in the future. In a causal relationship, the current system of regulations tends to deal withthe effects of liquidity shortage during recessions rather than with the causes, which can be referred to as distorted financial intermediation. In fact, regulations seek to cure symptoms rather than disease. The rules function like antibiotics,against which infection may develop immunity. We propose a modification of the current regulatory system and believe that this model should be taken into account when developing an effective regulatory framework for the financial system.

Flight to Safety or Liquidity? Dissecting Liquidity Shortages in the Financial Crisis

AbstractWe differentiate the liquidity and the quality of private assets in a tractable incomplete‐market model with heterogeneous agents. The model decomposes the convenience yield of government bonds into a “liquidity premium” (flight to liquidity) and a “safety premium” (flight to quality) over the business cycle. When calibrated to match the U.S. aggregate output fluctuations and bond premiums, the model reveals that a sharp reduction in the quality, instead of the liquidity, of private assets was the culprit of the recent financial crisis, consistent with the perception that it was the subprime‐mortgage problem that triggered the Great Recession. Since the provision of public liquidity endogenously affects the provision of private liquidity, our model indicates that excessive injection of public liquidity during a financial crisis can be welfare reducing under either conventional or unconventional policies. In particular, too much intervention for too long can depress capital investment.

A fiscal theory of money and bank liquidity provision

Fiscal-backed money can provide additional liquidity to consumers and mitigate the liquidity shortage problem in an economy with banks where agents face idiosyncratic liquidity shocks without being fully insured. The government issues fiat money and creates real value for money by levying a tax and accepting money for tax payments. Tax reallocates the distribution of liquidity in the economy. An increase in tax, by increasing fiscal surplus and the real value of money, reduces the equilibrium investment. Additionally, imposing taxes influences the incentive of private information production, which may impose a constraint on optimal fiscal policy.

Downside of Agency Banking in Nigeria

The study was conducted to investigate the downside of agency banking in Nigeria using Enugu South LGA of Enugu State as a case study. This study adopted the survey research resign. The survey was designed to elicit responses from respondents on the downside of agency banking in Enugu South LGA of Enugu State, Nigeria. The source of data was primary, obtained through the administration of questionnaire to agent bankers (POS operators) within the area of study. The population of the study consists of all POS operators in Nigeria. The sample size was calculated using the general formula for determining the sample size of an unknown population. The study used both descriptive and inferential statistics and the hypotheses were tested at 5% level of significance. It was found that robbery and liquidity shortage militate against the operation of agency banking. The study therefore recommends that the agent banker should ensure the availability of adequate cash that can reasonably serve customers without running into shortages or surplus of money while the government and commercial banks should partner in ensuring adequate security necessary for the operation of agency banking in Nigeria

Bank loans, trade credit, and liquidity shortages of small businesses during the global financial crisis

We investigate how small businesses responded to liquidity shortages during the financial crisis, focusing on heterogeneity between young and mature firms. With the sudden onset of the financial crisis, many small businesses faced declines in cash flows and liquidity shortages. Using over 4 million firm-year observations from Japan, we show that mature firms used bank loans more than young firms when facing liquidity shortages. This is consistent with previous studies indicating that banks offer liquidity provisions to firms with which they have close lending relationships. By contrast, trade payables did not largely increase for mature or young firms during the crisis. This suggests that mature firms relied on banks, not suppliers, for liquidity provision during the crisis. Furthermore, mature firms that experienced declines in cash flow during and after the crisis were likely to default and exit. This implies that credit allocation to mature firms is inefficient.

The role of credit lines and multiple lending in financial contagion and systemic events

Banks play a crucial role in providing liquidity to borrowers, particularly during crises (Kashyap et al., 2002 [33]). The existence of multiple lending relationships between banks and borrowers has been seen as an element that reduces the risk of liquidity shortage for debtors (Detragiache et al., 2000). In this paper, we aim to show how the interaction of these two aspects with solvency and liquidity requirements might have implications for the stability of the banking system, which might still need to be fully analyzed.We show that if other sources of liquidity are unavailable or too costly for banks, multiple lending might be a key element in a systemic liquidity shortage and a large drop in lending to the economy. These findings are particularly relevant for understanding how macroeconomic shocks, such as the relatively recent outbreak of COVID-19, could impact the real economy, as well as for assessing the implications of alternative banking resolution mechanisms.

Monetary policy uncertainty and corporate cash holdings: Evidence from China

This paper empirically explores the effect of monetary policy uncertainty on corporate cash holdings in China. We find robust evidence that monetary policy uncertainty is positively related to corporate cash holdings. The firms’ precautionary behavior in cash holdings is chiefly attributed to the increase in financial frictions rather than the reduction in corporate investments. The promoting effect of monetary policy uncertainty on cash holdings is more pronounced among firms with more severe financial constraints, firms with higher dependence on external finance, firms with worse access to bank financing, and non-SOEs, and during the period of monetary policy tightening. Our study suggests that firms hold more cash to cushion potential liquidity shortfalls induced by the increase in monetary policy uncertainty.

Working capital management and firm sales growth: Evidence from fish processing industry

AbstractWorking capital management (WCM) is a critical matter for the growth of firms, especially small and medium‐sized manufacturing companies faced with liquidity shortages whose current assets account for a significant part of their investments. These characteristics describe most companies in the fish processing industry. Using a sample of more than 1050 European fish processing companies during the period 2013–2020 and applying dynamic panel data methods, this paper analyses the extent to which working capital investment and financing policies affect firm's sales growth. The empirical evidence reveals that the trade credit channel (i.e., accounts receivable and accounts payable) enhances sales growth, while the opposite effect is found for investment in inventories. Additionally, the findings insist on the importance of financing current assets with positive working capital to boost sales growth. [EconLit Citations: C23, G31, L25, L79, Q22].

Green management, access to credit, and firms' vulnerability to the COVID-19 crisis.

The online version contains supplementary material available at 10.1007/s11187-023-00759-1.

Who borrows from the Eurosystem’s lender-of-the-last-resort facility?

We use a unique data set that comprises for each German bank its recourse to the Eurosystem’s marginal lending facility (MLF) along with a large variety of detailed bank level data including the daily liquidity position to study the drivers of banks’ recourse to the LOLR facility for the period January 2004 to October 2010. We find that larger banks and banks with lower liquidity buffers and higher idiosyncratic liquidity risks make more frequent and extensive use of the LOLR support. These results not only hold for crises periods and episodes of tight money markets but also for tranquil periods, irrespective of the different monetary policy regimes. Our results have two implications: First, they suggest that riskier banks benefit more from the LOLR-facility, which might affect competition in the financial sector, promoting riskier banks and foster risk-taking behaviour. Second, data on banks’ reserve management can be a useful tool for microprudential supervision to derive high-frequency indicators for predicting liquidity shortages at the individual bank level.

Renminbi Usage in Cross-Border Payments: Regional Patterns and the Role of Swaps Lines and Offshore Clearing Banks

The paper examines the usage of the Renminbi (RMB) as an international payment currency. Globally, the use of RMB remains small, accounting for 2 percent of total cross-border transactions. Using country-level transaction data from Swift** for 2010–21, we find significant regional variations in the use of RMB for cross-border payments. While RMB is little used in some regions, it has gained traction in others, and these cross-country differences have widened over the years. Such differences can be partly explained by an economy’s geographic distance, political distance, and trade linkages with China. However, it also reflects the impact of policy measures by the People’s Bank of China, including establishing bilateral swap lines and offshore clearing banks. Both policy measures helped to address offshore RMB liquidity shortages given China’s overall capital account restrictions, with the offshore clearing banks having a quantitatively larger impact. Our analysis contributes to a better understanding of the growing importance of RMB within the international monetary system.

Time Series Analysis in American Stock Market Recovering in Post COVID-19 Pandemic Period

: Every financial crisis has caused a dual shock to the global economy. The shortage of market liquidity, such as default in debt and bonds, has led to the spread of bankruptcies, such as Lehman Brothers in 2008. Using the data for the ETFs of the S&P 500, Nasdaq 100, and Dow Jones Industrial Average collected from Yahoo Finance, this study implemented Deep Learning, Neuro Network, and Time-series to analyze the trend of the American Stock Market in the post-COVID-19 period. LSTM model in Neuro Network to predict the future trend, which suggests the US stock market keeps falling for the post-COVID-19 period. This study reveals a reasonable allocation method of Long Short-Term Memory for which there is strong evidence