When Everyone Runs for the Exit

January 01, 2009

International Journal of Central Banking

The severe consequences for the global economy brought about by the 2008 liquidity crisis highlight the importance of liquidity risk.

Liquidity shocks are sudden, spill over across markets where levered traders have positions, and affect mostly risky and illiquid securities with large increases in margins. Liquidity events can happen even in the most liquid markets in the world, as was clearly illustrated by the sharp drop and rebound in the values of quant positions in U.S. large-cap stocks during August 2007.

While predicting liquidity crises in advance is very challenging, it is useful to understand whether price drops that already occurred were due to liquidity or fundamentals. This is because liquidity events present both risks and opportunities — liquidity-induced price drops tend to revert, and investors with dry powder can try to capture this rebound.

During a liquidity crisis, central banks can use unconventional monetary tools that improve the financing environment — e.g., by offering collateralized loans at lower (but still prudent) haircuts or margins. Even in good times, central banks need to reduce banks’ incentive to take on systemic risk by restricting reliance on funding that cannot be depended on during crises, or by limiting how large and levered positions investors takes. Even better, leveraged players themselves should be encouraged to limit how large an aggregate position they take relative to their capital.



  • AQR Capital Management, LLC, (“AQR”) provide links to third-party websites only as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by us of any content or information contained within or accessible from the linked sites. If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which AQR.com has no control. In no event will AQR be responsible for any information or content within the linked sites or your use of the linked sites.

  • The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees.

    This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.