Review of Environment, Energy and Economics - Re3 Illiquidity and all its Friends. A Discussion by Franklin Allen


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Illiquidity and all its Friends. A Discussion by Franklin Allen
by Franklin Allen
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This discussion by Franklin Allen was published as an appendix to Jean Tirole's paper "Illiquidity and all its Friends" when the paper was originally published as FEEM Nota di Lavoro 78.2010, prior to its publication in the Journal of Economic Literature in 2011, where the appendix no longer appears. Links to FEEM Nota di Lavoro 78.2010 and to all the other papers published by Jean Tirole in our working papers series are provided in the Links section at the bottom of the page, including an interview published in FEEM’s journal “Equilibri” and the FEEM lecture “New Finance, New Rules” delivered by Jean Tirole in 2009.

Suggested citation: Franklin, Allen, Illiquidity and all its Friends. A Discussion by Franklin Allen (November 6, 2014). Review of Environment, Energy and Economics (Re3),

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Jean Tirole’s paper provides an excellent coverage of the literature on the role of liquidity in crises and other related phenomena. He starts by outlining the important characteristics of the current crisis: (i) massive illiquidity; (ii) market freezes; (iii) fire sales; (iv) contagion; and (v) insolvencies and bailouts. He then relates these events to the academic literature on market breakdowns due to: (i) adverse selection; and (ii) shortage of financial muscle. He then provides a macroeconomic perspective based on aggregate liquidity shortages; and draws policy conclusions on (i) mark to market (ii) monetary versus fiscal bailouts and (iii) the need for macroprudential regulation.

Two frameworks are primarily used in this analysis. The first is the seminal paper Holmstrom and Tirole (1998). As is well known, the basic theme of this paper is that “finance as you go” may be prevented by market failures due to asymmetric information and other imperfections. The alternative is “liquidity hoarding” where firms hold assets to enable them to survive and keep investing. The key issue then becomes whether there are enough liquid assets in the economy to allow firms to undertake this hoarding. If not then the public sector may need to provide such assets.

The second is Farhi and Tirole (2009), which is also a seminal paper. This develops a model where there are strategic complementarities between banks in their choice of debt levels because of the reaction of the monetary authorities in setting monetary policy. If all banks become highly levered then when there is a negative shock there will be a systemic crisis that affects many banks. This leads the authorities to engage in a monetary bailout where they set low short term interest rates to allow banks to recuperate their financial position due to the positive spread between short term and long term interest rates. There may also be fiscal bailouts where the government simply provides funds to banks. Strategic complementarities between bank strategies caused by government policies create a need for macroprudential policies by the government to prevent banks from using so much leverage.

In this discussion, I will develop a parallel analysis of the crisis to underline the factors that I think are important in addition to those stressed by Jean (see also Allen and Carletti (2009)). Despite its severity and its ample effects, the current crisis is similar to past crises in many dimensions. In a recent paper, Reinhart and Rogoff (2009) document the effects of banking crises using an extensive data set of high and middle-to-low income countries. They find that systemic banking crises are typically preceded by credit booms and asset price bubbles. This is consistent with Borio and Lowe (2002) and Herring and Wachter (2003) who show that many financial crises are the result of bubbles in real estate markets. In addition, Reinhart and Rogoff find that crises result, on average, in a 35% real drop in housing prices spread over a period of 6 years. Equity prices fall 55% over 3 ½ years. Output falls by 9% over two years, while unemployment rises 7% over a period of 4 years. Central government debt rises 86% compared to its pre-crisis level. Reinhart and Rogoff stress that the major episodes are sufficiently far apart that policymakers and investors typically believe that “this time is different.”

The seeds of the current crisis can be traced to the low interest rate policies adopted by the Federal Reserve and other central banks after the collapse of the technology stock bubble. In addition, the appetite of Asian central banks for (debt) securities contributed to lax credit. These factors helped fuel a dramatic increase in house prices in the U.S. as shown in Figure 1 and several other countries such as Spain, Ireland and the U.K. In 2006 this bubble reached its peak in the U.S. and house prices there and elsewhere fell.

What caused the illiquidity of many financial markets that has characterized the crisis and is the focus on Jean’s paper? After the real estate market peaked in July 2006, severe financial market problems started about one year later after it had become clearer that the run-up in real estate prices had been the first phase of a bubble. The start of the collapse in the real estate bubble had a dramatic effect on the pricing of many mortgage-backed securities. Despite having been rated triple-A by the credit rating agencies, these prices fell dramatically, particularly for those securities backed by subprime mortgages. Many of these mortgages were held in Special Investment Vehicles (SIVs) financed by short term debt. This funding quickly dried up once it became clear that the underlying securities were worth much less than the original prices they were issued at. One of the important questions is why the prices of the securitized mortgages fell so quickly.

One leading possibility covered by Jean is liquidity factors. Once investors realized that these mortgages were more risky than had been initially thought, many readjusted their portfolios by selling. This led to a fire sale and a collapse in prices. Once the link between prices and fundamentals had been broken limits to arbitrage prevented this link from being re-established. In other words, it became risky to buy the securities on the assumption their price would move up because before this happened they might continue to fall.

A second possibility is that there was adverse selection in the market. Observing the quality of these securities is difficult. As a result sellers of the securities have an incentive to sell the low quality ones and keep the high quality ones. In anticipation of this, buyers will only pay a very low price.

A third possibility that has received little attention is that prices of these securities fell precipitously because of the nature of the adjustment process of real estate prices. Whereas stock prices adjust very quickly to the arrival of new information, real estate prices do not. The decentralized nature of these markets and the fact that many participants are not well informed means that price adjustment takes time. In bubble episodes there is thus serial correlation in price movements. This makes it very difficult to price mortgage backed securities and this makes them illiquid. These two factors together can provide an explanation of the discounts of 60-70 percent that were seen in these markets.

One of the most surprising aspects of the crisis was the fact that so many people in the U.S. ignored the possibility that real estate prices were a bubble. Many similar episodes had occurred in Asia and Europe and numerous observers had pointed to the fact that there was probably a bubble in U.S. property prices. For example, The Economist newspaper ran frequent articles pointing out that a crash in property prices was likely. Despite this many investors appeared to attach zero probability to the possibility of a fall in real estate prices in their analysis.

What caused the bubble? The first factor is that the monetary policies of central banks particularly the US Federal Reserve were too loose – they focused too much on consumer price inflation and ignored asset price inflation. Holding interest rates at 1 percent when house prices were rising at a faster rate in 2003 and 2004 made it very attractive to buy houses. This was especially true given the tax deductibility of interest on mortgages compared to no deductibility of rent and various government policies designed to encourage poor people to own their own homes. These incentives to buy sparked a housing price bubble. Once housing prices were moving upwards at a fast rate, the bubble continued even though interest rates were subsequently raised. There was still an incentive to purchase because of the rapid increase in prices.

However, the low interest rate policies of the Federal Reserve are not sufficient to explain why many other countries such as Spain and Ireland also had property bubbles. Here interest rates were not as low in absolute terms. The second important factor responsible for the bubble is global imbalances. The origin of these dates back to the Asian crisis of 1997 and the policies of the IMF. Countries with fundamentally sound economies like South Korea were forced to raise interest rates and cut government spending when they needed help. This was precisely the opposite of what the U.S. and Europe did when faced with a crisis. Moreover these policies caused great economic dislocation in South Korea. Many companies were bankrupted and unemployment soared from around 3 percent to above 9 percent. Other Asian economies were similarly affected by these harsh policies. Asian countries are under-represented in the governance and staffing of the IMF. This meant that they could not effectively protest and have the policies imposed on them in exchange for assistance reversed. After the crisis was over Asian countries concluded that it was better to accumulate reserves to ensure they did not need to approach the IMF in the future. Figure 2 shows this accumulation of reserves by China, Chinese Taipei,. Hong Kong SAR, Japan, Singapore and South Korea It can be seen that in contrast Latin American and central and eastern European countries did not accumulate reserves during this period.

These Asian reserves were mostly invested in debt securities, primarily Treasuries and mortgage-backed securities. This lead to a lowering of credit standards as financial intermediaries tried to find outlets for all these funds. This lowering of credit standards was also an important contributor to the housing bubble that occurred in the U.S. and other countries.

The private sector has come into considerable criticism for excessive risk taking. There is little doubt that the massive leverage adopted by many investment banks and hedge funds has contributed to the severity of the crisis. However, in my view it was excessive risk taking in the public sector that was a more important cause of the crisis. When the Federal Reserve held interest rates at unprecedentedly low levels in 2003 and 2004, they were taking a great risk. Although they avoided a serious recession then, they laid the foundations for the current severe crisis. Although central bank independence is good for preventing inflation it is not desirable for financial stability. Central banks have very little constraints in adopting new and risky policies. Because of his dominance of the Board of Governors of the Federal Reserve System, the decision to lower interest rates to such low levels was effectively made by one man, the Chairman, Alan Greenspan.

A current example of risk taking by the public sector is quantitative easing. This involves the central banking creating money for the purpose of buying back longer term securities to try and drive down long term interest rates. This has not been tried very much before and therefore its effects are not well understood. Once again the Federal Reserve is taking a large risk. There has been very little discussion of this. One exception is a speech by Chancellor Angela Merkel in Berlin on June 2, 2009. She argued that the Federal Reserve and the Bank of England should stop the unconventional monetary policy of quantitative easing as it was sowing the seeds of the next crisis. The next day Chairman Bernanke politely replied that with respect he disagreed. However, since then the Federal Reserve has tempered its policy and voices within the Federal Reserve have raised concern about inflation from these policies.

Having the German Chancellor break with long tradition to discuss the policies of other countries’ central banks is probably not an optimal governance mechanism for the Federal Reserve. What are needed are more checks and balances within the system. One possibility is to impose a duty of financial stability on the Federal Reserve. Another is to reform the operational procedures of the Federal Reserve so that the Chairman has less power and the Presidents of the regional Federal Reserves have more. The Board itself can thus act as more of a check than is currently the case.

Even if the Federal Reserve and other central banks can be reformed to curb public sector risk taking, there would still be the problem of global imbalances. It was argued above that these have arisen as a result of the Asian crisis of 1997. The acquisition of reserves has worked very well for the countries that have done it. For example, South Korea has fared much better in this crisis than in 1997. Its large reserves have meant that it did not need to go to the IMF and could make its own decisions. It lowered interest rates and raised government expenditures like other countries. The exchange rate suffered as a result but in fact this was beneficial as it helped prevent a precipitous drop in economic activity. For example, whereas Japan’s GDP fell 4.0 percent in Quarter 1 of 2009, South Korea’s increased by 0.1 percent despite their having similar export-oriented economies.

However, for the other countries in the world the acquisition of reserves has not been advantageous since it is arguably a major contributor to the crisis. It has been a very inefficient mechanism from a global perspective. In addition it is very costly in terms of lost consumption for the country acquiring the reserves. If their high level is maintained then this is a permanent loss. A better system would probably be to have ex post sharing of risk. A situation where the IMF lent money to countries having difficulties would not involve these drawbacks. However, the current governance system prevents the IMF from fulfilling this role as the Asian countries do not trust that they will be treated fairly. Current proposals to reform the IMF do not solve the problem as they still leave China and South Korea in particular under-represented.

The Chinese have proposed a global currency to replace the dollar as the major reserve currency. This would presumably operate something like the IMF’s Special Drawing Rights (SDRs). This would run into the same governance problem in that an international organization would be needed to run it and the Asian countries would need to be assured that they would be properly represented. A third possibility is that the renminbi becomes fully convertible and as a result can itself become a reserve currency. With the dollar, the euro and the renminbi as major reserve currencies, the Chinese would not need to hold reserves and other countries would be able to diversify their foreign exchange reserve currency reserves much better than at present. This is probably the best feasible long run solution but will take several years to implement.

Reforming central bank governance and solving the global imbalance problems are not the only two reforms that are needed. Reducing the possibility of future crises and mitigating their effects will require other key reforms.

“Too big to fail” is not “Too big to liquidate”
The actions of governments in bailing out large financial institutions have laid the seeds for future crises by creating significant moral hazard. Large institutions know that they will not be allowed to fail. If they have problems the government will step in and save them. This encourages them to take significant risks and benefit when these are successful while the government bears the cost of failures. In order to prevent this moral hazard, the owners and managers of financial institutions must be faced with the consequences of their actions. The reason for not allowing banks to fail is that this causes contagion as in the case of Lehman in September 2008. However, it is possible to prevent contagion while at the same time limiting moral hazard by liquidating any bank that requires government help to avoid failure. Enforcing this kind of policy would be a significant step forward.

Resolution of large complex cross-border financial institutions
A major difficulty in designing a framework that allows financial institutions to be liquidated is how to deal with large complex cross border institutions. In particular, there is the problem of which countries should bear any losses from an international mismatch of assets and liabilities. This has proved a thorny problem for the European Union in designing a cross border regime to support its desire for a single market in financial services. For countries without political ties like the EU it is an even more difficult problem. Designing such a system is one of the most urgent tasks facing governments.

Limited government debt guarantees for financial institutions
In the current crisis bank bondholders have effectively had a government guarantee. There is an important issue of whether this is desirable. Such a guarantee prevents disorderly wholesale runs. However, this again provides undesirable long term precedents. Going forward holders of bank debt will know it is guaranteed and will not have any incentive to exert market discipline. If failing banks are nationalized and liquidated in an orderly manner as discussed above, it should be possible to impose losses on long term bondholders and other debt holders. This should provide incentives for market discipline by bondholders.

Removal of tax subsidies for debt
The tax system in many countries subsidizes the use of debt in many ways. For example, in the U.S. mortgage interest is tax deductible. Also interest is deductible for the purposes of the corporate income tax. These kinds of incentives to use debt are not desirable in a financial stability context. They should be removed.

Capital adequacy regulation should be based on market capital as well as accounting capital
Capital adequacy rules have an important role to play in preventing contagion and other problems. However, one aspect of their current implementation is that they are based on accounting capital. When Wachovia failed last year its accounting capital was above regulatory limits even though the market was no longer willing to provide funds. This example underlines the importance of using market capital in regulation, in addition to accounting capital.

Mark-to-market or historic cost accounting?
Financial institutions have traditionally used historic cost accounting for many of their assets. This is problematic if assets fall in value as the financial institutions are able to hide this fact for significant periods of time. A good example is the S&L crisis in the U.S. in the 1980’s. This kind of episode encouraged a move to mark-to-market accounting in by the IASB and U.S. FASB (see, eg Plantin, Sapra, and Shin (2008) and Allen and Carletti (2008a)). During the current crisis where it is not at all clear that market prices reflect fundamental values, mark-to-market accounting has come under severe criticism by financial institutions and has been relaxed by the FASB under political pressure from Congress.

How should the advantages and disadvantages of mark-to-market accounting be balanced? As long as markets are efficient, mark-to-market accounting dominates. However, if as during times of crisis they cease to be efficient, market prices do not provide a good guide for regulators and investors. The key issue then becomes how to identify whether financial markets are working properly or not. Allen and Carletti (2008b) suggest that when market prices and model based prices diverge significantly (more than 2% say), financial institutions should publish both. If regulators and investors see many financial institutions independently publishing different valuations they can deduce that financial markets may no longer be efficient and can act accordingly.

A role for public sector banks in a mixed system
Some countries such as Chile with its Banco Estado have a publicly owned commercial bank that competes with private sector banks. In times of crisis, such a bank can expand and help stabilize the market as all market participants know that it is backed by the state and will not fail. At the moment, that is what the Federal Reserve is effectively doing. They have become one of the biggest commercial banks in the world. But the employees of the Fed do not have much expertise in running a commercial bank. They don't know much about credit risk. They are mostly macroeconomists who are interested in monetary policy. It would be better to have expertise in the public sector which allows the state to perform commercial banking functions during times of crisis.


Allen, F and E. Carletti (2008a). “Mark-to-Market Accounting and Liquidity Pricing,” Journal of Accounting and Economics 45, 358-378.

Allen, F. and E. Carletti (2008b). “Should Financial Institutions Mark to Market?Bank of France Financial Stability Review 12, October 2008, 1-6.

Allen, F. and E. Carletti (2009). “The Global Financial Crisis: Causes and Consequences,” working paper, Wharton Financial Institutions Center, University of Pennsylvania.

Borio, C. and P. Lowe (2002). “Asset Prices, Financial and Monetary Stability: Exploring the Nexus,” Bank for International Settlements Working Paper 114, Basel, Switzerland.

Farhi, Emmanuel, and Jean Tirole (2012) "Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts." American Economic Review, 102(1): 60-93.

Herring, R. and S. Wachter (2003). “Bubbles in Real Estate Markets,” in Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies edited by W. Hunter, G. Kaufman, and M. Pomerleano, Cambridge: MIT Press.

Holmström B., and J. Tirole (1998). “Private and Public Supply of Liquidity,” Journal of Political Economy, 106: 1-40.

Plantin, G., H. Sapra, and H. Shin (2008). “Marking-to-Market: Panacea or Pandora's Box?Journal of Accounting Research 46, 435-60.

Reinhart, C., and K. Rogoff (2009). “The Aftermath of Financial Crises,” American Economic Review 99, 466-72.



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Interview in Italian, "Nuove regole, nuova finanza", in FEEM's journal "Equilibri"

FEEM Lecture, May 12, 2009, “New Finance, New Rules”









Frankliln Allen, Nippon Life Professor of Finance and Economics, The Wharton School of the University of Pennsylvania