Wednesday, March 12, 2008

On Liquidity and Leverage

"Liquidity and Leverage" by Tobias Adrian and Hyun Song Shin sounded promising:
Our findings also shed light on the concept of "liquidity" as used in common
discourse about financial market conditions. In the financial press and other market
commentary, asset price booms are sometimes attributed to "excess liquidity"
in the financial system. Financial commentators are fond of using the associated
metaphors, such as the financial markets being "awash with liquidity", or liquidity
"sloshing around". However, the precise sense in which "liquidity" is being used
in such contexts is often left unspecified.

In general, I thought the paper's writing could be tightened. The above quote from the introduction needs to make it explicit that the kind of liquidity that is being talked about in the press is the funding liquidity that is in the paper. I know, I know, for some people like me, I need to be based over the head with things mainly because I'm not versed in the financial jargon. The abstract was meaningless to me because of my lack of familiarity. I may as well have been reading something about game theory. The paper is a nice length and readable although the section on existing literature seems to be standing by itself. The authors didn't try too hard to tie together the literature with what they are doing. It looks as though a referee made them put it in and they did.

1. The main item that I thought the authors should have emphasized more was the implications of the forecastability of the VIX index of implied volatility using aggregate intermediary balance sheet size (again, the authors could be less jargoned as just say size of short term lending measured using repos). If I'm reading this right, they are saying that "risk appetite" (again they need to make this term clearer) as proxied by the VIX can be forecasted. What are the implications? If we use the repos position as a predictor for future volatility then can we expect increase use of repos in the next period? Some papers have shown that merger activity increases as share prices increases -- can these be tied to the use of repos?

2. My main interest in the paper was the increase in liquidity that could be accounted for by marking to market. Unfortunately this was not attempted (and I don't know if it can). The authors use the repos positions of five investment banks to empirically verify the procyclity of marked-to-market leverage. This put a damper on things since the introduction seemed to indicate that they would address what it means to be awash in liquidity. If 5 investment banks can wash the world in liquidity then the financial system can't be too stable.

3. The abstract really needs to be catchier which means shorter sentences. Here's my 2 cent rewrite:
In a financial system where balance sheets are continuously marked to market, asset price changes show up immediately in changes in net worth. When asset prices go up, financial intermediaries increase their use of leverage. Marked-to-market leverage is strongly procyclical. The aggregate consequence of this behavior is to increase the risk appetite of financial intermediaries. Changes in the marked-to-market-leverage can predict innovations in risk appetite as proxied by the VIX index. The aggregate liquidity in the financial system can now be clearly seen as the rate of change of the balance sheets of financial intermediaries.

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