Preliminary Evidence on the Relation between Economic Uncertainty, Financial Stress and Liquidity Risk

This study examines the relation between economic uncertainty, financial stress, and liquidity risk. The empirical evidence suggests that the inner dynamics of settlement fails for a given type of security are not likely to change in isolation from similar events for alternative securities, nor are they independent from the perceived levels of financial stress. There are limited signs of market segregation as the volumes of fails for various types of securities including treasury notes and corporate securities tend to follow similar patterns. The repurchase market does not seem to be a place where failure paves the way for success. It may be argued that near-zero interest rates and quantitative easing programs are reshaping the behaviour of financial institutions faced with increasingly complex trade-offs in the repurchase markets. It is increasingly difficult to reconcile the regulatory demands for larger holdings of safe assets with the imperative of generating incremental income from risk-free assets, and with the economic function of liquidity provision. Thus, it is important to manage risk in ways that recognize uncertainty as inherent to all economic activities and promote equity over debt financing. It is important for financial institutions and financial regulators to draw lessons from the recurrence of financial crises and shift away from debt-financing toward equity-linked securities and partnership agreements, which are conducive to sustainable finance and economic development.