Financial stability is pragmatically defined as a predetermined condition in which the financial system-intermediaries, markets, and the market structures can withstand shocks without any significant disruption in financial intermediation and the ultimate general supply of financial services (Eaton, 2012). Macro prudential Policy articulates on the prevention of the extensive build up risks resulting from diverse external factors and the market failure so as to smoothen the financial cycle and also making the financial sector more resilient and limit contagion effects.
Market liquidity is pragmatically referred to the ease in which one asset can be traded for another. Market or asset liquidity is considered vital aspect because it allows diverse investors to transact at a reasonable size at or even close to prices prevailing in the particular market before the trade.
Market liquidity matters because it contributes to the markets that are efficient. Market liquidity being one of the concepts of liquidity matters a lot because the aspect allows diverse investors or shareholders to carry on the transaction at a reasonable size or choose to the prevailing prices in the whole market prior to trading perspectives (Landau, 2011). Liquid markets usually play a significant role in the financing of investment in the actual economy because suppose the value of bonds goes up, the investors will gain a lot of returns from their invested funds. The aspect of market liquidity should be maintained at a higher level because the investors do not welcome any resultant reduction in market liquidity.
United States of America bond market: International Monetary Fund (IMF) finds that market liquidity worsening since there is the presence of liquidity deterioration in the values of the bonds.
Changes in the investors base through the higher concentration of holdings among the mutual funds or even greater investor homogeneity may have increased liquidity risk (Landau, 2011). This aspect will be enhanced through proper adjustments of the investors base so as to increase their particular returns.Investors who invest in less resilient liquidity have the capability of increasing the aspect of liquidity risks because most of them will decide to spend on mutual funds that have a higher concentration of holdings among the funds.
Equal access to trading platforms is vital because investors will have to gather reliable information on matters that pertains investments. Trading platforms offer investors with diverse information that will assist them in making prior decisions on or before making any investment.
Central banks must be mindful of the side effects on liquidity of the market that arises from their policies on outright purchases and collateral of securities because a lot of policies that the central banks impose on the market so as to strengthen the collateral requirements or to reduce risks may make the provision of collateral to be more expensive (Barbulescu, 2014). The central banks large-scale securities purchases under traditional monetary procedures are expected to have affected market liquidity both negatively and positively by relaxing funding constraints, dropping default and term premiums, and lifting risk appetite; and negatively by decreasing the supply of certain bonds and thus rising market participants costs for searching.
The central bank policy on outright purchases and collateral of high-quality government debt securities may be declining the collateralizable securities total amount and also contributing to decreased liquidity in the market. Tighter funding restraints for trading stimulated by changes in regulations and business models have perhaps worsen dealers risk-taking capacity or enthusiasm to make markets and reduced banks proprietary trading activities (Landau, 2012). Less market making obstructs the matching of sellers and buyers, thereby increasing the costs of search. New policies in the primary jurisdictions have also affected search amounts both negatively and positively in diverse asset markets.
The 2007-2008 global economic crises were preceded by the slow growth in developed nations subsequently resulting in a sharp slowdown in emerging nations. To counter the sharp slowdown, the emerging markets switched to development models that were dependent on credit. Consequently, a double-digit annual credit growth drove the economic activities of these emerging economies (Barbulescu, 2014). The IMF has thus considered the corporate leverage to be problematic due to reasons that include:
The level of government debts are not high, but the involvement of the state in banks and the industry accentuate that the effective level of obligations by the state are higher than what has been stated.
The exposure to emerging markets by the banks and investors are significantly high. The use of borrowing, unfortunately, has been used to finance expenditure, infrastructure investments that have tentative rates of returns.
The quasi-government bank officials in emerging countries have financed projects that are politically linked in terms of businesses and politicians. The practices on lending are thus weak and hence assist in financing property and grand vanity projects that are expensive and have dubious economics.
The corporate debt in up-and-coming nations economies has substantively risen in the earlier period. The growth and the changing nature of the emerging corporate debt have taken place amid unprecedented expansion monetary policies in economies already advanced and change in the global financial landscape (Matysek-Jedrych, 2014). Emerging markets firms have subsequently come across a greater incentive and opportunities to increase the leverage substantively as a result of the ensuing unprecedented favorable global financial conditions. The accommodative global monetary conditions encourage substantively affected the emerging through the following channels:
The central banks in emerging nations have set lower policy rates compared to what they would otherwise respond to the prevailing low-interest rates in already advanced economies thus alleviating the currency appreciation pressures.
Advanced economies have purchased large scale bonds that reduced the bond yield not only to in their markets but also to a varying degree in emerging markets through portfolio balancing effects (Barbulescu, 2014).
The changes in the policy rates in advanced economies have promptly been reflected in the burden of debt-financing outstanding in emerging markets foreign denominated debt. Through such a channel, the expansionary global economic conditions thus facilitate a greater corporate leverage through the relaxation of borrowing constraints in emerging economies.
The key risks that are derived from the emerging market corporate sector are encapsulated by the reversal of the post-crisis accommodative worldwide financial conditions. Companies that are conspicuously considered as most leveraged stand to ensure the rise in their debt-service amounts once the monetary guidelines rates in the advanced economies start to increase. Additionally, the rate of interest risk can substantively be aggravated by the rollover and the currency risks. Although financing using bonds tend to substantively have a longer time to mature than financing through banks, it substantively exposes the firm to financial market conditions that are more volatile (Matysek-Jedrych, 2014). In addition to the risk identified, the depreciation of the local currency which is effectively associated with the rise in the policy rate in economies that have already advance would make it increasing difficult for the emerging markets firms to adequately service their foreign currency denominated debts if hedging is not carried out adequately.
The shocks to indebted may lead to spill over to the monetary sector and also trigger a vicious cycle through banks curtail lending. The corporate debt usually comprises of a considerable share of rising market banks assets because of the growing concentration of the aspect of indebtedness that results to the weaker tail of the firms. The corporate leverage increases in the market and thus leading to the indebted firm being much vulnerable to shocks that may arise due to the level of indebtedness that has hit the financial institutions (Valente, 2011). When the level of leverage increases in any financial market, the diverse firm is subjected to shocks that usually trigger the aspect of vicious cycles. This aspect usually leads to shocks to the corporate sector and can lead to the financial sector generating vicious cycles.
Barbulescu, M., & Radulescu, M. (2014). Price Stability versus Financial Stability in Romania. Challenges to Financial Stability - Perspective, Models and Policies Volume II. Towards Financial Stability - Macroprudential Policy and Perspectives, 123-151. doi:10.14505/cfs.2014.ch16
Eaton, G. W. (2012). The Effects of Market Liquidity on the Firm: Does Liquidity Impact Firm Value? SSRN Electronic Journal. doi:10.2139/ssrn.2756563
Landau, J. (2011). Macroprudential Policy: Central Banking Reconsidered. Macroprudential Regulatory Policies, 89-102. doi:10.1142/9789814360678_0007
Lee, J. (2014). (The Effects of Monetary Policy Announcements on Stock Market Liquidity). SSRN Electronic Journal. doi:10.2139/ssrn.2580679
Matysek-Jedrych, A. (2014). The Changing Nature of Central Banks Accountability for Financial Stability. Challenges to Financial Stability - Perspective, Models and Policies Volume II. Towards Financial Stability - Macroprudential Policy and Perspectives, 23-43. doi:10.14505/cfs.2014.ch11
Momirovic, D. M., Stankovic, S. J., & Petkovic, M. B. (2014). Central Bank Policy and Macroprudential Policy in Ensuring Financial Stability. Challenges to Financial Stability - Perspective, Models and Policies Volume II. Towards Financial Stability - Macroprudential Policy and Perspectives, 105-122. doi:10.14505/cfs.2014.ch15
Valente, G. (2011). Market Liquidity and Funding Liquidity: An Empirical Investigation. SSRN Electronic Journal. doi:10.2139/ssrn.1632059
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