Excess Liquidity Creation of Banks and Financial Market Peaks

Abstract

Mutually reinforcing dynamics between the market liquidity of financial assets and the funding liquidity risks of financial intermediaries were one of the reasons why asset prices declined so significantly with the onset of the financial crisis in 2007. Based on this observation, I show how an excessive rate of funding liquidity risk-taking by financial intermediaries can be used as a timing measure for an upcoming peak of equity market prices in Germany for the time period 1973 to 2010. Funding liquidity risk-taking is thereby defined as the degree of liquidity creation by banks. The working hypothesis is that if banks create liquidity at an excessive rate, then the German equity market will reach a significant peak at or shortly after the peak in the liquidity creation activity of the banking system. The proposed early warning indicator predicted all peaks on the equity market in Germany for the time period 1973 to 2010 with an average lead time of 2.9 months. Hence, the rate of liquidity creation seems to provide very useful information about the future state of financial markets. The early warning indicator can be applied in real-time.