Home > Economics > What is a Liquidity Event?

What is a Liquidity Event?

James D. Hamilton, professor of economics at the University of California writes in his blog, Econbrowser:

It was an exciting week in financial markets, including some dramatic central bank interventions in short-term money markets.

First, a little background on what we’re talking about here, focusing on the U.S. system with which I am most familiar. Banks that are members of the U.S. Federal Reserve System hold accounts known as Federal Reserve deposits. These deposits play a fundamental role in interbank financial transactions. If a bank wants more currency, it can obtain it by converting its Federal Reserve deposits to cash. Checks are often cleared by debiting the Federal Reserve deposits of the bank on which the check is drawn and crediting those for the receiving bank. Wire transfers are also implemented by a transfer of deposits between banks.

If you followed an individual dollar of Federal Reserve deposits, you would find it moving between banks a very large number of times each day. However, none of these interbank transactions would change the total value of Federal Reserve deposits. New deposits can only be created by an act of the Fed itself, either in the form of an open market operation (in which the Fed credits a particular bank with new deposits in exchange for receipt of another asset of equal value) or a discount window loan (in which the Fed loans deposits to the bank, holding other assets from the bank as collateral).

Banks try to hold as few of these deposits as possible, since they do not pay interest. However, banks are required to hold minimum levels of deposits based on the dollar value of checking accounts issued. Banks could alternatively meet some of these requirements by holding physical cash instead, and the sum of this cash plus deposits is known as reserves.

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Categories: Economics
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