【08金融危机必读系列】The Global Economic System

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TLAC in resolution. As you know, the FSB and the Basel Committee have proposed total loss-absorbing capacity in resolution. Why TLAC? In the event of resolution, global systemically important banks need to have sufficient loss-absorbing debt to allow an orderly resolution that avoids falling dominoes, maintains critical functions and minimises taxpayers’ risk. Both bondholders and shareholders should have a stake in banks’ managing risk properly. An impact study is scheduled to be published by August; calibration is to be done by September; endorsement by the G20 Leaders is expected in November; and implementation may be as early as January 2019.

Calibration of the leverage ratio. Since risk models and risk weights – no matter how sophisticated – do not fully capture all relevant risks, the leverage ratio in Basel III serves as the suspenders to the risk-weighted belt. It guards against model risk and “unknown unknowns”, putting a limit on the growth of banks’ leverage. It is often said that the minimum leverage ratio is set at 3%, but let us be clear that its level remains to be decided. The commitment is to finalise calibration by 2017, and this work could well be completed before then.
• Other items. There is other work in progress on the regulatory agenda. This includes revisions of the standardised approaches and their adaptation to set floors for firms’ own model results; a fundamental review of the trading book; disclosure of the Net Stable Funding Ratio; and work on the simplicity, comparability and risk sensitivity of the regulatory framework.

The global economic crisis of 2008 and 2009 caught many of the most
astute investors in the financial markets by surprise. While only 49
hedge funds failed during all of 2007, 344 hedge funds failed during
just the third quarter of 2008, and another 778 hedge funds failed
during the fourth quarter of 2008. Similarly, while only 3 banks failed
in 2007, 25 banks failed in 2008, and 140 failed in 2009. Endowment
funds, the financial backbone of private universities, which had posted
stellar investment results throughout the 2000s, had an investment
return of -19% during fiscal 2009. The four biggest funds, with widely
acclaimed investment managers, posted returns of -27% (Harvard),
-25% (Yale), -27% (Stanford), and -23% (Princeton). Private equity
funds lost 15% in 2008.
As a description of the money management industry during 2008-
2009, one of the most widely circulated quotes was provided by the
“sage of Omaha,” Warren Buffet, who once said “you only find out
who is swimming naked when the tide goes out.”1 So how did some of
the smartest investors, who had generated outsized returns for a long
time with their skills, get caught flat-footed by the largest financial crisis

Chapter 1 Motivation for Understanding Liquidity Risk . . . 1
1.1 Peso Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Liquidity Risk—The Peso Problem of
Our Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.3 WorldCom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.4 Hedge Fund Returns . . . . . . . . . . . . . . . . . . . . . 6
1.5 The Structure of This Book . . . . . . . . . . . . . . . . 8
Endnotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Chapter 2 Liquidity Risk: Concepts . . . . . . . . . . . . . . . . . . 11
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2 What Is Liquidity? . . . . . . . . . . . . . . . . . . . . . . 11
2.3 Model of Liquidity Costs . . . . . . . . . . . . . . . . . 15
2.4 Liquidity Risk and Liquidity Shocks . . . . . . . . 21
2.5 Liquidity Risk Premium . . . . . . . . . . . . . . . . . . 25
2.6 Why Bear Liquidity Risk? . . . . . . . . . . . . . . . . 32
2.7 Liquidity-Driven Investing (LqDI) . . . . . . . . . 34
2.8 Liquidity Risk Exposure in Bank
Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
2.9 Propagation of Liquidity Shocks:
Systemic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2.10 From Liquidity Crisis to Credit Crisis . . . . . 50
Endnotes . . . . . . . . . . . . . . . .

1.2 Liquidity Risk—
The Peso Problem of Our Time
In this book, we argue that there was a peso problem during the
period leading up to the global economic crisis of 2008-2009. And we
also argue that it was an extremely pervasive peso problem, touching
our entire society. It is present in every market (both financial and
nonfinancial), it affects most financial institutions ranging from banks
to hedge funds, it has always been there, and it will always continue to
be there. This latent risk factor is liquidity risk.
Liquidity risk is a term widely used now in the popular press, but
the truth is that few practitioners or academics seem to understand
this risk well. Perhaps not surprisingly, because until just a few years
ago, there was very little work being done to analyze this risk factor.
The purpose of this book is not only to provide a detailed description
of the concept of liquidity risk but also to lay out how this risk affects
financial institutions and thereby gets transmitted into the global economic
system. We do the latter by providing an analysis of the effects
of three prominent liquidity risk events in the 20th century: 1) the
Great Depression of the 1930s, 2) the collapse of the asset price bubble
in Japan during the 1990s—often called the Lost Decade, and 3)
the global economic crisis of 2008-2009, which, at the time of the
writing of this book, many would argue is still continuing.
Before we get started, we provide a bit of additional motivation to
study liquidity risk by presenting a couple of puzzles. These are some
of the puzzles that initially prompted us to begin researching the concept
of liquidity risk and its effects on financial institutions and the
global economy.
3

1.3 WorldCom
WorldCom was one of the largest telecommunications companies in
the world. Due to accounting fraud, in July 2002 the firm filed for
bankruptcy. At the time it was the largest bankruptcy filing in the history
of the United States.2
Figure 1.1 shows a time-series graph constructed using
WorldCom’s stock price movements over the two years prior to its
bankruptcy. This graph depicts the assessment of WorldCom’s probability
of default3—or the risk that it would not pay its debt holders—
by the equity markets over a period of time. The probability of default
at any one point in time is calculated utilizing a widely used model
known as the Merton model.4 The only information being used in the
calculations is data from the equity markets—no bond market information
is used. Therefore, one can interpret Figure 1.1 as representing
the equity market’s probability of default assessment of
WorldCom.
THE GLOBAL ECONOMIC SYSTEM
4
WorldCom Risk-Neutral Default Probability
0
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Nov-00 Feb-01 Jun-01 Sep-01 Dec-01
Time

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