ERIM Research Clinic: Liquidity black holes
Liquidity black holes arise when financial market liquidity suddenly dries up. Trading financial assets becomes prohibitively expensive and asset prices tank. Examples of liquidity black holes are the 1997 Asian crisis, the 1998 Russian debt / LTCM crisis, and the 2007-2008 subprime mortgage crisis. Liquidity black holes are self-reinforcing. Falling prices lead to further selling because financial traders hit their loss limits and are forced to liquidate their positions. As a result, financial markets break down. Liquidity black holes can have severe economic consequences. First, they can cause financial institutions to fail (for example the recent bank run on Northern Rock), undermining the confidence in the financial system. Second, they can disrupt the economy by blocking companies’ access to capital. This lecture will discuss the general functioning and consequences of liquidity black holes, as well as some specific mechanisms proposed by a recent theoretical study.
Brunnermeier, M.K., and L.H. Pedersen, 2009, “Market Liquidity and Funding Liquidity,” Review of Financial Studies 22, 2201-2238. (especially pages 2201-2207 and 2226-2232)
(From outside of the campus, please make use of the ERNA-VPN.)