The Amplification Mechanism Of The Liquidity Crisis

Liquidity had played a vital role in the development of subprime crisis. To some extent, the subprime crisis can be viewed as a liquidity crisis. This paper studies the amplification mechanisms of the liquidity crisis based on the related literature. And the paper combined with the policy of the major economies, brings forward some policy to keep down the liquidity crisis's amplification.This paper divides the evolution of the liquidity crisis into two parts: initiation part and the amplification part. In the initial phase of the liquidity crisis, the USA housing prices declined, and the default frequency of the subprime mortgage rose, then the market value of the financial products based on the subprime mortgage shrank. At this stage, only the financial institutions which hold financial products based on the subprime mortgage suffered the book losses. Liquidity crisis's amplification can be divided into three stages. At the first stage, the investors didn't know how many losses the subprime mortgage related assets had made. So the investors on one hand began to sell the subprime mortgaged related assets; on the other hand, investors began to revulsion capital from the money market resulting the expression of liquidity scarce. As a result, the financial institutions had to set about their deleveraging, for the pressure of the decreasing value of the subprime mortgage related assets. At the second stage of the liquidity crisis amplification, the fluctuations in the U.S. financial market affect other financial markets, then the cross-market linkages between the financial markets significant increase. The contagion between the financial markets occurred. In the third stage of the liquidity crisis amplification, because of the losses from the commercial banks'risk assets, the commercial bank began to decrease the loan to the other bank,residents and enterprises, then credit crunch come out. The credit crunch had substantial impact on consumption and investment. Overall decline in consumption and investment made the U.S entering recession. After that, the recession in the USA made the emerging markets suffering shock through the trade channel.This paper has studied on amplification mechanism of the liquidity crisis from the perspectives of investors'flighting to liquidity, deleveraging of financial institutions, financial contagion across markets and the decline of the real economy due to credit crunch.From the perspective of investors'flighting to liquidity, the amplification mechanism of the liquidity crisis has to do with lack of knowledge and uncertainty. The response of investors to their uncertainty was to disengage. Investors went back to the drawing board to formulate new models. In the meantime, given that they did not have a clear understanding of events, they took decisions to protect themselves against worst-case scenarios on the risks that they did not understand. The result of all of this disengagement was a loss of liquidity, with many attendant effects.From the perspective of deleveraging of financial institutions, the amplification mechanism of the liquidity crisis has to do with management of the balance sheet. For financial intermediaries, their models of risk and economic capital dictate active management of their overall value at risk (VaR) through adjustments of their balance sheets. There is a negtive relationship between leverage and VaR. In the crisis, VaR of assets has greatly increased, so the financial intermediaries has to reduce the leverage ratio. That resulted in a sharp contraction of the balance sheet.From the perspective of financial contagion, the amplification mechanism of the liquidity crisis has to do with expectation of investors. the impact of crisis changed investors'expectation and led investors to take the consistent view of the macro fundamentals.When the investors made similar decisions, the correlation between different markets increased. Our Empirical Study shows that the correlation between the U.S. currency market, U.S. bond market, U.S. stock market and A-share market had significantly increased in the crisis. The liquidity crisis of U.S. had significant contagion effect on A-share market.From the perspective of the decline of the real economy, the amplification mechanism of the liquidity crisis has to do with credit crunch. Credit crunch inhibited U.S. consumption and investment. So U.S. output declined. Furthermore, the decline in U.S. output would affect the real economy of U.S. trading partners through trade channels. Our empirical study shows that when the logarithm of U.S. GDP fell 1 unit, China's exports to the U.S. would reduced by 0.89 units.This paper also made some policy recommendations on containment of amplification of liquidity crisis. First, the monetary authorities should play the role of the credit bank and adjust the structural scarcity of liquidity. Second, timely relief policies should be made to restore market confidence. Third, supervision of financial derivatives should be strengthened. Fourth, countries in Asia with high savings should seek to change the mode of economic growth. Fifth, mechanisms for international cooperation should be established to jointly cope with the crisis.