Liquidity: Concepts, Ideas and the Financial Crisis

The financial, or subprime, crisis has brought attention to the importance of the market for liquidity for the broader financial markets. Many commentators identify the beginning of the crisis with the sharp increase in the Libor‐OIS spread during the second week of August 2007, when this spread tripled. Subsequently, the spread continued its rise and interbank volume fell, especially at the longer end. In short, there was a breakdown in the interbank market for liquidity. To combat this, central banks around the world injected vast amounts of liquidity into the banking system to counteract banks' unwillingness to lend to each other.
The problems in the interbank market appear to have propagated to other markets. Lending of banks to non‐bank businesses also fell, and the prices of stocks and other securities decreased dramatically. The way events unfolded during the crisis suggests that there is a link between the market for liquidity and the broader financial markets, and an important question is whether different assets are affected to a different degree by changes to the price of liquidity. For example, does the degree of liquidity of a security affect its sensitivity to the price of liquidity in the interbank market?
In this paper, we essentially do two things. First, we provide an overview of the crisis from the perspective of the market for liquidity. This also includes taking a look at what happened to the stock markets as the price of liquidity rose to dizzying heights and then fell back to less dramatic levels. Second, we review the financial economics literature on liquidity, with an eye towards understanding the various measures of liquidity that have been developed and their merit. Most of this literature focuses on the stock markets. The objective is thus to set the stage for further work down the line that looks more closely at the liquidity link between the interbank and stock markets.