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ASB-3201
INTERNATIONAL BANKING
Course Work Project

Lecturer
Dr. Ru Xie

Faisal Jaafar Darbas

500358960

Mahmood Qassim

500363060

Khalid Rashdan

500360394

Abdulla Faqihi

500358961

Yousif Alhussaini

500361039

Hassan Alhashemi

500361878

Funding liquidity risk describes the possible chances that over a given period of time a bank
could become unable to settle responsibilities with imminence. Market liquidity risk describes
the extent to which it may be hard to sell an asset fast enough to evade losing of money or in
order to make a profit.
The normal background to measure funding liquidity risk relates the likely collective cash
deficits over a given period against the stock of available funding sources. The problematic part
this outline is how to allocate cash flows to the future times, more so on financial products with
irregular cash-inflow timing. Financial products of that kind are referred to as having unspecified
maturity (Allen, 2008). Because products with indeterminate cash-flow timing make up a
significant portion of a typical depository institution, then an accurate understanding of these
products liquidity risk characteristics of a significant practical importance to measure funding
liquidity risk.

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The quantifiable extents of funding liquidity risk include balance sheet ratios, net cash capital
position, maturity mismatches and funding ratios. However, a significant portion of bank
financial products has uncertain cash-flow timing, according to (Brunnermier, 2008). As a result,
banks face two central problems in measuring funding liquidity risk. i.e.

Allocating cash flows to future time for financial products with

indeterminate timing.

Determining the more stable and less stable portion of financial products
with indeterminate cash flow timing.
Bank regulators face the same problems on setting and monitoring quantitative prudential
funding liquidity requirements.
The measure is constructed using a data set of main refinancing operation auctions in Europe.
Funding liquidity can be measured in limits. The collective supply of is determined by the
European Central Banks. The auction itself is price discriminating because every up-and-coming
bidder should pay the bidding fee. At marginal rates bidding fees can be rationed so as everyone
can take the same amount of the remaining liquidity. The marginal rate represents the interest
rate, which associates cumulative demand with total allocation.

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The measure therefore based on the amount banks bid at rates above the expected minimal rate.
The central bank adjusts the supply of liquidity when all the bids have been received. The market
anticipates this when forming their expectations on marginal rate and the total volume allocation,
which is required as the input in the measure of funding liquidity risk. The problem is further
deepened by relationship between cumulative bids and the total allocation. Hence, there is need
to rely on new survey dataset from Reuters, where market expectations about marginal rate of
each auction are revealed.
Measurement of funding liquidity risk using readily available information is proposed since
measurement with indeterminate definitions is not possible. In line with other risks funding
liquidity risk can be measured by summarizing the stochastic nature of the fundamental risk
factors. Distributions of this nature are hard to estimate for data is unavailable. Through handing
in competitive bids at the central bank, the bank may insure itself against becoming illiquid and
thus it reveals it liquidity risk.

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From the data set conducted by European Central Banks from 2005 to 2010, one can note that
funding liquidity risk improved swiftly in 2007 and remained steady after the free of Northern
Rock. The measure also points record pressures in 2008 after the failure of Lehman. The measure
has similar properties as the market liquidity risk for instance, low levels, persistence and
infrequent spikes. It is possible to find evidence for the existing relationship between funding
liquidity risk and market liquidity risk. This analysis is only an initial position in using bidding
data to examine funding liquidity risk. It would be interesting to implement the measure for
limits.
There is a provision of a comparison with banks on their own measure of funding liquidity risk
and how it relates to their behaviors in bidding. The widely used measure to assess market
condition is the spread between unsecured interbank rates and the overnight index swap rate.
Although, spreads are not clear way of measuring funding liquidity risk because the following
reasons:

Funding liquidity risk is not the only way of measuring the spread between

interbank rates. There is complement credit risk. These components are difficult to
disentangle.

Interbank market rates are not a complete representative of actual funding

situations during a crisis due to high levels of uncertainty, spread in the credit quality
across banks and greater incentives to strategically give false reports on funding costs.

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Interaction of Funding Liquidity and Market Liquidity
Evident from the German Stock Market
The daily data for the period between 2003 and 2011 is applicable in this. In this part one look at
real evidence for relations between bank funding liquidity risk and market liquidity risk in the
Germany market. One can look at the relationship between the refinancing of market markers of
specific stocks traded and the liquidity of the stock for the period 2003 to 2011. This analyzes the
mechanisms linking the liquidity on funding and asset markets. In particular, this assesses the
hypothesis that tight funding situations cause speculators to reduce their trading activity in order
to meet their liquidity requirements. Besides the actuations in interbank markets for liquidity, one
argues that liquidity provision of central banks may affect this interaction, in particular during
times in which central bank intervention is high. In order to decrease the requirements for
liquidity holdings, reducing trading in illiquid, i.e. high-margin asset markets are
disproportionately more ejective for speculators. Therefore, one expects to observe flight-toliquidity mechanisms when funding markets become tight. That is, market liquidity in liquid and
illiquid markets drifts apart, with liquid markets becoming more liquid relative to illiquid ones.

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This analyzes the relation between funding liquidity and market liquidity on an aggregate basis.
In line with 2010 one finds a strong co-movement of banks' funding liquidity conditions and
stock market liquidity, which is particularly pronounced for generally very illiquid stocks.
Interestingly, after August 2008{when interbank markets froze the impact of the aggregate CDS
of market makers on the overall stock market {liquidity declined due to the provision of excess
liquidity by the European Central Bank (ECB). Apparently, the ECB's substantial liquidity
injections not only decoupled banks' refinancing conditions from their credit risk premium it also
loosened the relation between banks' credit risk premium and their liquidity provision to the
stock market.
There is also use of a dynamic panel model with stock and time fixed effects to study the impact
of designated sponsors' funding conditions on stocks' market liquidity on a stock-by-stock basis.
The results reveal that also on the micro level, the refinancing conditions of market makers
significantly affect the liquidity of their stocks. Interestingly, it is clear that tighter refinancing
conditions particularly impair the liquidity of generally rather illiquid stocks, while usually very
liquid stocks become relatively more liquid.
This paper is related to different strands of the literature. Most importantly, it contributes to the
literature providing empirical evidence on the interaction of funding liquidity and asset markets.
In line with the outcomes of our analysis, they find a positive relationship between funding and
stock market liquidity on aggregated levels and that this relationship is stronger for illiquid
stocks than for liquid ones. In addition, they find flight-to-quality mechanisms to be particularly
strong during the financial crisis and thus, in times of (relatively) low liquidity in stock markets.
Furthermore, using only aggregate measures of interbank market liquidity they cannot pin down
how precisely banks' funding liquidity affects stock market liquidity. They cannot disentangle

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whether it is only that banks generally cut back their lending and thus, force other market
participants to reduce their securities holdings, or whether it is that banks indeed directly reduce
their positions held in financial assets.
Using the micro level data one is capable of providing the evidence that indeed the latter effect
contributes to the co-movements. Thus, this paper provides thorough empirical evidence for the
theoretical effects of funding liquidity on market liquidity by Brunnermier (2009). First, they use
percentage effective spreads to approximate the liquidity costs traders actually face as a more
sophisticated liquidity indicator. Second, they use panel data on New York Stock Exchange
(NYSE) specialist revenues and inventories. Their results show that effective spreads increase
when specialists pile up large positions or make losses on their inventories.
Thus, the authors are the first to provide evidence that capital constraints of market makers in
specific stocks affect for the stock market liquidity on a stock-specific level. However, revenues
and inventory items of specialists are measuring capital constraints rather than liquidity
constraints. Consequently, their study does not provide evidence for negative externalities of
banks' liquidity shortages and potential liquidity spirals and does not contribute to the discussion
about the need for tighter liquidity regulation.
In a broader context, the impact of monetary announcements on market liquidity, for instance,
has been well documented in the past. From 2005 discover that monetary policies drive bond
market liquidity while in 2003 reveals similar results for stock markets. More recently, in 2009
suggest that monetary policies affect stock markets through liquidity fluctuations in bond
markets. Likewise, cash flows of investors seem to directly link to price fluctuations in equity
markets.

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This provides evidence in favor of these hypotheses looking at the German stocks traded on and
their designated sponsors' funding situation between 2003 and 2011. Daily CDS spreads is used
as a proxy for sponsors' ease to receive financing on the interbank market, and the Liquidity
Measure as a superior measure of true order book depth. In addition to the analysis of aggregated
liquidity data, we are able to apply a panel regression model. The results provide strong support
for the above hypotheses, in particular:
(i) On an aggregate level, the liquidity of interbank funding markets co-moves with the liquidity
of stock markets. The co-movement is large for illiquid stocks and small for liquid ones. The
outcome seems to confirm that speculators decrease their trading activity when funding becomes
tight.
(ii) Taking into consideration the activities of the European Central Bank, it is clear that the
interaction mechanisms between interbank markets and stock markets persist. However, it is
evident that the marginal effects on the average stock market liquidity are amended. While for
the time before 2008, excess liquidity provided by the ECB remains largely irrelevant for stock
market liquidity, it is clear that the dependency of stocks market liquidity on the liquidity in
interbank funding markets decreases with increasing levels of central bank liquidity provision.
(iii) The general co-movement in the liquidity of markets may not be generally observed when
using a panel approach with time-fixed effects as time trends are removed. It is possible to
explain this when taking into consideration the heterogeneity in the long-term liquidity levels
among stocks: As the analysis shows, tight funding affects the market liquidity of rather liquid
stocks positively while it reduces the liquidity of rather illiquid ones. The outcome evidences
flight-to-quality mechanisms triggered by changes in the funding ease of speculators. The

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funding is robust to changes in the provision of central bank liquidity and all other common
impacts due to the time fixed-effects considered.
(iv) The level of heterogeneity in stocks increases over time and is particularly strong during and
after the financial crisis of 2008. This implies the effect of increasingly many speculators who
face substantial funding constraints and thus, reduce the liquidity provided to stock markets.

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Concluding from these findings, we find strong evidence for the liquidity spillover between
interbank funding markets and asset markets. This is in line with the predictions of recent
academic research. In addition, the consideration of central bank interventions provides new
insights and contributes to understanding these mechanisms. As illustrated by the most recent
financial crisis, a profound understanding of market liquidity is crucial for the stability of
financial systems and the prosperity of economies. This is considered as the central task of future
research.

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Bibliography
Allen, Franklin, and Elena Carletti. "The role of liquidity in financial crises." Available at SSRN
1268367 (2008).
Aikman, David, Piergiorgio Alessandri, Bruno Eklund, Prasanna Gai, Sujit Kapadia, Elizabeth
Martin, Nada Mora, Gabriel Sterne, and Matthew Willison. "Funding liquidity risk in a
quantitative model of systemic stability." In EFA 2009 Bergen Meetings Paper. 2009.
Brunnermeier, Markus K., and Lasse Heje Pedersen. "Market liquidity and funding liquidity."
Review of Financial studies 22, no. 6 (2009): 2201-2238.
Diamond, Douglas W., and Raghuram G. Rajan. Liquidity risk, liquidity creation and financial
fragility: A theory of banking. No. w7430. National Bureau of Economic Research, 1999.
Gatev, Evan, Til Schuermann, and Philip E. Strahan. "Managing bank liquidity risk: How
deposit-loan synergies vary with market conditions." Review of Financial Studies 22, no.
3 (2009): 995-1020.