The Liquidity Problem

The Traditional View of Liquidity

Within the U.S. economy, the central bank, officially known as the Federal Reserve (or the “Fed” for short), has been seen as the source of banking system liquidity.

The Federal Reserve can alter the supply of money by: changing bank capital requirements, changing interest rates, or by old fashioned money printing. Banks then create liquidity by making loans.

Banks benefit from involvement in the Federal Reserve System in the following ways:

  • The U.S. government insures the deposits held in participating banks; insurance instills confidence and reduces the risk of a “run” on the banks.
  • Banks can borrow money through the Federal Reserve’s discount window.

Participation in the Federal Reserve System is not without its constraints, as capital requirements imposed by the Fed restrict financial leverage and can require banks to raise additional capital.

An Alternative View of Liquidity

The financial crisis, which began in 2008 illustrated that financial vehicles outside the traditional banking system also created liquidity through alternate methods.

These “non-bank” vehicles included hedge funds, collateralized debt obligations, asset backed securities, real estate investment trusts, and other investment instruments.

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