Game of Liquidity: Why the flow of money matters

In the first weeks of the COVID-19 pandemic, as the extent of the damage the economy and financial markets would suffer started to become clear, the U.S. Federal Reserve and the Bank of Canada made a series of increasingly large announcements that showed central banks were willing to go to whatever extent necessary to prevent liquidity from drying up.

In fact, when the first measures were announced (and deemed too mild) already battered markets actually took another tumble, only inching up once central banks and governments came back with the fiscal and monetary policy “bazookas” they had been hoping for.

Those may have been extraordinary times, but the rush to provide liquidity to the financial system showed just how important the flow and availability of money and credit is not just for markets but also for the financial system overall. It’s the plumbing that keeps money moving from those who have it to those who need it – everyone from investors to companies and mortgage lenders. If those pipes get clogged, and money doesn’t flow, the whole system finds itself in a whole lot of trouble just like it did, for entirely different reasons, during the 2008 credit crunch.

So what exactly is liquidity?

Liquidity refers to how easy it is for an asset to be sold for cash. It’s “liquid” because it flows from its current state into money.

But liquidity also refers to the amount of money that flows through the financial system: from one bank to another, from banks to people who need to borrow money to buy a car or a home, or to those who need money to fund business expenses. It also speaks to markets, and how easy it is for traders to buy and sell equities or bonds among themselves, at a price that’s as close as possible to the asset’s intrinsic value.

And just like money needs to flow from banks to their customers or between traders who need cash to buy the assets others are selling, it also needs to flow within society.

If people don’t have money to buy goods (either because they lose their jobs or because they’re afraid to), companies would, in theory, eventually see such a drop in revenues that they would halt production. If companies stop producing, they then lay off staff and there’s even less money to go around.

Unlike other recessions and crises, which were caused by stock market glitches or problems in the financial system, the precipitating effect in 2020 was a worldwide pandemic that forced part of the economy to shut down to keep people safe. Companies were faced by shortages in both demand from consumers and in supply, as the global shutdown hit the supply chains that deliver their products. But as these businesses increasingly relied on their lines of credit to pay their bills and stockpile cash (as well as withdrawing whatever money they’d deposited so they could cover expenses), banks found themselves at risk of losing much of their liquidity.

Just like people stockpiled toilet paper at the onset of the pandemic, investors, banks and companies tried to stockpile cash. And the easiest way to get cash was to sell liquid assets.

For investors, that meant liquidating risky stocks and high-yield bonds first to buy safer assets like treasuries. But as panic spread and the need for cash became, in people’s minds, greater than anything else, even treasuries began to sell-off.

Buying and selling is what investors do. It’s usually not a problem, as long as there’s a somewhat even number of buyers and sellers. But when everyone is selling at the same time (either to meet margin calls, because they need the cash to cover expenses or because they’re panicked and want out) and no one wants to give up the little cash they have, anyone wanting to buy will need credit. And in times of crisis, credit is typically in short supply.

Bonds are one way to access credit, but if the math doesn’t make bond issuance appealing to companies, those firms turn to the banks.

Most companies will have lines of credit they can access, but if all these firms are trying to grab as much cash as possible at the same time, banks’ balance sheets get a little wonky. There are certain things banks can do to balance these and to make sure they can both comply with regulatory requirements and continue to issue loans – up to a point.

When they run out of options, banks turn to the Federal Reserve (in the U.S.) and the Bank of Canada north of the border, which, by launching quantitative easing and repurchase programs can take assets off a bank’s hands so that they can expand lending. These are measures that governments and central banks threw all their might behind to fight the economic impact of the pandemic in 2020.

It’s the role of central banks to ensure financial stability by acting as a lender of last resort and provide liquidity to make sure we have a stable and reliable financial system. Time will tell if the measures applied during any particular crisis were executed with the right force.

But they are important steps to take, because once companies and other borrowers understand liquidity will not dry up, they can stop stockpiling. That takes pressure off the system and helps it to stabilize – much like when shoppers stop hoarding bread and toilet paper at the grocery store and there’s once again enough to go around.

7 months ago