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Credit Crisis as a Factor of Financial Market Liquidity Research Paper


Executive Summary

The liquidity of financial markets is inseparable from developments in the economic environment, and the credit crisis is one of them. Therefore, the two phenomena under consideration are interrelated. The most significant risks are connected to cases when there are no bids in the market or under a specific condition in the banking sector, especially when banks do not have enough capital. In similar cases, they do not have relevant resources for funding their clients, i.e., providing them with the required loans.

This situation is generally referred to as a credit crisis. Sometimes, determining the initial cause of financial market imbalances is complicated, in other words, to conclude whether it was low market liquidity that led to a credit crisis or the credit crisis resulted in decreased market liquidity. Nevertheless, in most cases, the impact of a credit crisis on the liquidity of financial markets is negative. In the most severe instances, it is associated with a state known as illiquidity.

Under such conditions, there are no participants in the market because they temporarily disappear. Regardless of the overall negative influence of credit crises on financial market liquidity, it is true only in the case of inefficient markets. This means that if the markets are efficient (i.e., if prices adjust to the latest economic developments), the influence of crises on the liquidity of financial markets is insignificant. This can be explained by the fact that investors rarely cease their operations inefficient markets; rather, they continue injecting funds regardless of undesirable developments in the market.

Impact of a Credit Crisis on Financial Market Liquidity

Developments in the economic environment are directly associated with the key determinants of financial markets. Liquidity is one of the major aspects of markets that is inseparable from changes in the economy. When speaking of the most significant economic developments, it is essential to point to the existence of credit crises. The two—financial market liquidity and credit crises—are inseparable. They are interrelated because, in most cases, it is complicated to determine the cause of the change, which means establishing whether it was low financial market liquidity that led to the outbreak of a credit crisis or the latter entailed unexpected decreases in liquidity.

Regardless of the interconnectedness of the two economic phenomena, it is essential to keep in mind that liquidity is a determinant of markets and is highly dependent upon the specificities of a particular market. From this perspective, the most critical liquidity risks are associated with no bids in the market—the situations when dealers shut down—and insufficient or no capital in banks. In the latter instance, banks do not possess enough capital to provide their clients with loans. This means that they cannot fund customers. The situation mentioned above is generally referred to as a credit crisis.

Therefore, the paper at hand aims to identify the connection between credit crises and financial market liquidity. However, the idea is not to investigate the overall interrelation. Instead, the paper will focus on discerning the impact of a credit crisis on financial market liquidity. This means that the main objective of the research is to conclude whether this impact is different in different markets and under different economic conditions or is universal for all markets and economic players (including banks), in terms of generally negative or positive. All conclusions will be made based on a comprehensive literature review.

Literature Review

Search Methodology

A literature review is a foundation for finding the answer to the central research question: What is the impact of a credit crisis on financial market liquidity? Therefore, to address this question effectively and find an accurate answer, it is essential to review relevant literature sources. To maximize the appropriateness and timeliness of resources, several inclusion criteria have been defined. First, several search requests have been formulated to maximize opportunities for locating relatable sources: “the impact of the credit crisis on the financial market liquidity,” “credit crisis and financial market liquidity,” “connection between credit crises and financial market liquidity,” “causes of decreases in financial market liquidity,” and “factors leading to financial market illiquidity.”

Moreover, there are no limitations for the nature of the sources to incorporate different opinions on the existing influence of a credit crisis on financial market liquidity. This means that all located materials published in peer-reviewed articles, textbooks, and magazines, or posted online, along with expert opinions and other scholarly and non-scholarly papers will be considered.

However, there is one significant exclusion criteria—date of publication. It is planned to analyze only sources younger than 5 years to guarantee the timeliness of the sources and accuracy of conclusions. Still, little attention will be paid to the place of publication. Instead, a focus will be made on the language. In this way, all materials published in English will be reviewed, and no sources will be ignored based on the region of publication.

Differences in the places of publication may be a positive contribution to research outcomes due to the comprehensiveness of the findings because of the different perceptions of the problem across the globe. Moreover, some statistical material will be analyzed to support the theoretical findings and come to appropriate conclusions.

Research Findings

The essence and value of liquidity in financial markets

In general terms, market liquidity is the ability to sell and purchase items. This characteristic does not differ across markets or economies. It is a unique feature of all economic environments, with the only difference in the proposed product. In the case of financial markets, the main products are assets. In this way, financial market liquidity is the ability to purchase or sell assets. However, it is essential to point to several critical factors in determining the concept of financial market liquidity.

To begin with, the price of assets must be considered. Liquid assets are those that can be sold or bought with minimal price impact. Under ideal circumstances, there is no price impact at all. Moreover, it is essential to pay attention to the quantity of sold or purchased assets. From this perspective, financial market liquidity is associated with selling or purchasing large volumes of assets (“Market liquidity and financial stability,” 2015). Based on the specificities of this economic phenomenon, financial market liquidity is of high value to investors because it is directly associated with their risk-free and profitable operation in the market.

However, in this case, it is essential to pay special attention to the average liquidity, not the liquidity of particular assets, because it is the only way to determine the real situation in the financial market. That said, the role of liquidity in the market is connected to the fact that it is one of the determinants of the stability of financial markets. The latter is one of the factors that either make a market attractive for investors or demotivate the latter to allocate their funds in particular economic environments (Madura, 2018; “Market liquidity and financial stability,” 2015). Also, financial market liquidity is the determinant that identifies access to a particular market.

This means that higher market liquidity is synonymous with easier access to markets—the ability to invest freely—while low market liquidity is associated with the inability to assess market development and inject funds when desired due to increased risks of turmoil (“Importance of liquidity for the functioning of financial markets,” 2017).

The connection between credit crises and financial market liquidity

A credit crisis is commonly connected to changes in financial market liquidity. In most cases, the influence is negative, and the most significant liquidity risks are connected to the existence of a bubble in the financial market (Allen, 2013).

The critical factor of this development is the impossibility to predict further changes in a particular economic environment that lead to uncertainties about the future price level. It is especially critical in the case of inefficient markets that are known for the poor ability to adapt to market and economic changes. In this way, it affects the desire of economic players to become involved in market activities and determines asset supply and demand—the foundation of the financial market liquidity.

Moreover, credit crises are connected to negative changes in banking operations. Although they are, for the most part, caused by imperfections in the banking systems, credit crises lead to further negative developments in this sector. Due to the increased role of banks in the capital market, they are influential as well in identifying the average market liquidity (Berger & Bouwman, 2016). Compared with other undesirable developments in the economic environment, credit crises lead to uncertainty regarding the price of assets (Caprio, 2013).

This means that investors are not sure whether they can purchase or sell large volumes of assets with minimal or no price impact. In similar cases, it is safer for them to cease market activities and leave the market. The latter situation is referred to as illiquidity, and it is the most negative impact of the credit crisis on financial market liquidity because, in this instance, assets are completely illiquid—they cannot be purchased or sold.

In general, it is essential to point to the fact that the impact of credit crises on the financial market liquidity is significant because of the difficulties in managing market liquidity. This means that even if it is possible to predict negative developments in the economic environment or the emergence of credit crises, it is extremely complicated to forecast the behavior of investors—the main actors of financial markets (Karakach & Otieno, 2016). From this perspective, because financial market liquidity is directly associated with the supply and demand of assets in the market, problems in managing major economic players and controlling their decisions are the major outcome of credit crises that leads to liquidity issues.

Market development and the impact of a credit crisis on financial market liquidity

Madura (2018) points to the connection between the specificities of markets and the impact of credit crises. The author identifies two types of financial markets: efficient and inefficient. The difference between the two is the ability to adapt to the existing economic conditions whether they were forecasted or not. From this perspective, efficient markets are those characterized by their easy adaptation to new market developments—either positive or negative.

On the other hand, if markets cannot adjust to economic changes, they are inefficient. Speaking of the impact of a credit crisis on financial market liquidity, it is more notable and significant in the case of inefficient markets because they are inflexible and more exposed to risks. Efficient markets, instead, are flexible so that reactions to any economic change are less critical and the influence of a credit crisis on financial market liquidity is less considerable (Madura, 2018).

Furthermore, it is paramount to note the difference between primary and secondary financial markets. In most cases, secondary markets experience more negative consequences of credit crises compared to primary markets. The existence of this phenomenon can be explained by the level of investor trust in particular market institutions. From this perspective, investors tend to be more confident in primary financial markets than secondary ones. This means that primary financial markets are, for the most part, efficient, while secondary markets are not. Therefore, the connection between primary and secondary markets and the role of credit crises in determining their liquidity is the same as in the case of efficient and inefficient financial markets.

Recent credit crises and their impact on financial market liquidity

The 2008 crisis has pointed to the overall negative influence of credit crises on financial market liquidity. This can be explained by one of the outcomes of the crisis: insufficient levels of liquid assets (Cabral, 2013). Based on one of the specificities of financial market liquidity—the ability to sell and purchase large quantities of assets—the impact is critical because available assets were either associated with high liquidity premiums (significant price impact) or were not backed up by banks (low liquidity in the future) (Macerinskiene, Ivaskeviciute, & Railiene, 2014). The same is true about the 1990s Asian crisis that resulted in significant drops in financial market liquidity due to the inability to conduct the necessary quantity of market operations (Charoenwong, Ding, & Yang, 2012).

Speaking of the impact of credit crises on financial market liquidity, it is essential to emphasize the fact that the issue has become even more critical due to the globalization trend in the global economy. Because of this trend, there are increased risks of spillovers between different markets, both primary and secondary.

Also, because the world is becoming more open, there is an opportunity for carrying out operations in different financial markets around the globe. Because of this factor, the same investors may be involved in different economic environments. This means that if they cease participating in several of them, all of these markets will experience changes in overall financial market liquidity. Based on this idea, any uncertainties in prices caused by credit risks affect global investors that, in turn, will affect their motivation to allocate funds (Caprio, 2013).

Discussion and Analysis

Based on the research findings presented above, it is evident that all the authors agree that the impact of credit crises on financial market liquidity is essential (Karakach & Otieno, 2016; Macerinskiene et al., 2014; Madura, 2018; Cabral, 2013; Caprio, 2013). However, in addition to the way that liquidity differs over markets and economic environments, markets are susceptible to the influence of credit crises in a different way.

Therefore, the level of market development is what affects the significance of the impact of credit crises on financial market liquidity. From this perspective, efficient and primary markets are less influenced by credit crises, compared to secondary and inefficient ones (Madura, 2018).

In addition to the criticality of understanding the impact of credit crises on financial market liquidity, it is essential to point to the fact that the recent global financial crisis has revealed the necessity of developing universal frameworks that would minimize the risks of subsequent credit crises, thus contributing to the stabilization of average financial market liquidity and the overall health of financial markets. These rules should focus on managing liquidity risks by obliging banks to have enough capital to support their operation as well as satisfying their customers’ needs for loans, thus avoiding potential credit crises (Macerinskiene et al., 2014).

Conclusion

In summary, financial market liquidity is one of the major determinants of financial market development. Still, it is directly connected to other changes in the external economic environment. From this perspective, financial market liquidity differs over time and markets. Nevertheless, it is possible to identify the most critical factors that lead to increased risks to the stability of financial market liquidity. These include the absence of bids in the market (dealer shutdowns) and credit crises. The latter term refers to situations when banks cannot satisfy the need of customers for loans due to the lack of capital or having no free capital at all.

Even though it is essential to keep in mind that, in some cases, it is low liquidity of financial markets that leads to credit crises, these instances are not the focus of the study. Instead, there are some trends in the impact of credit crises on financial market liquidity. In general, this influence is negative. However, just like liquidity differs over markets, the impact of crises does as well. That said, it can be either insignificantly negative of extremely critical.

The latter is referred to as the condition of illiquidity—a situation when all participants of the financial market disappear due to negative developments in the economic environment. Regardless of the risks of illiquidity, it is paramount to state that it is not true for all markets. Instead, similar outcomes are possible only in the inefficient markets—those that are characterized by an unnatural establishment of prices. Speaking of market efficiency, any market is perceived as efficient if prices are easily adaptable to changes in the economic environment and are determined based on them. According to this difference, inefficient markets, investors never disappear.

This means that the influence of a credit crisis on the liquidity of efficient financial markets is insignificant because investors keep on injecting funds, as these markets are easy to monitor. On the other hand, credit crises may lead to the destruction of inefficient financial markets due to the impossibility to predict market changes and price levels that are directly connected to investors’ desire to allocate funds in particular economic environments (Madura, 2018). The same connection is true in the case of secondary and primary markets, as primary markets are less susceptible to the impact of credit crises compared to secondary markets.

References

Allen, W. A. (2013). International liquidity and the financial crisis. New York, NY: Cambridge University Press.

Berger, A. N., & Bouwman, C. H. S. (2016). Bank liquidity creation and financial crises. Waltham, MA: Elsevier.

Cabral, R. (2013). A perspective on the symptoms and causes of the financial crisis. Journal of Banking & Finance, 37(1), 103– 117. Web.

Caprio, G. (Ed.). (2013). The evidence and impact of financial globalization. Waltham, MA: Elsevier.

Charoenwong, C., Ding, D. K., & Yang, Y. C. (2012). . Web.

. (2017). Web.

Karakach, G., & Otieno, R. O. (Eds.). (2016). Economic management in a hyperinflatory environment. New York, NY: Oxford University Press.

Macerinskiene, I., Ivaskeviciute, L., & Railiene, G. (2014). The financial crisis impact on credit risk management in commercial banks. Web.

Madura, J. (2018). Financial markets and institutions (12th ed.). Boston, MA: Cengage.

. (2015). Web.

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IvyPanda. "Credit Crisis as a Factor of Financial Market Liquidity." November 18, 2020. https://ivypanda.com/essays/credit-crisis-as-a-factor-of-financial-market-liquidity/.

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IvyPanda. 2020. "Credit Crisis as a Factor of Financial Market Liquidity." November 18, 2020. https://ivypanda.com/essays/credit-crisis-as-a-factor-of-financial-market-liquidity/.

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