Does Liquidity of Capital Market Assets Have Any Consequences for the Banking System?

The term "capital markets” refers to a very broad set of institutions that deal with the buying and selling of all kinds of securities, both debt and equity. It is the market where firms go to raise money and finance their operations. Its liquidity refers to the rapidity and ease of its motions, how easy it is to buy and sell securities. In short, liquidity refers to the volume of trade. A highly liquid market is one that is in rapid motion, with much trading.

The “liquidity” of capital market assets refers to the ability of these assets to be bought and sold. It lies at the root of any capital market, whether bonds or stocks. Its consequences for the banking system are more or less indirect but still significant.

The basic role of banks, speaking generally, is to maintain a strong, stable and predictable “infrastructure” of finance. Banks seek long-term relationships with their customers, and are all corporations not unlike the typical publicly traded firm. Historically speaking, the strength of a banking system -- that is, its stability and professionalism -- have always had a strong impact on the volume of markets, that is, their liquidity. The reverse is also true: strong, active and liquid markets have helped banks grow and make money. They work together to create both a strong yet active and liquid economic system.

When a capital market, say the bond market, is called “highly liquid,” it just means that this market is trading debt rapidly and constantly. This can mean that there is a great deal of uncertainty about future interest rates, so the increasing rapidity of trading might reflect that. This does not have to be the case, however. If markets are trading rapidly -- suggesting a highly liquid environment -- then banks can be affected. If rates are low, this might mean that firms go to the money markets for financing rather than banks. Banks and debt markets, in a sense, are competitors.

A highly liquid stock market, one with high volume, can lead to a greater demand for bank loans and assistance for investment purposes. If banks are an important way to get money to then invest in equities, the strength and liquidity of these markets might serve banks very well. In general, rates for bonds should be low, or else buying debt might be a better option. This bypassing of banks might do damage to their financial standing.

One of the most important effects the capital markets liquidity might have on banks is to provide constant, rapid and accurate signals concerning the cost of capital in all kinds of these markets. Both stock and bond markets, taken together, give an accurate and strong picture of the economic situation. Interest rates, volatility and liquidity, capital gains and market values are all important and central forms of information that banks can take from the volatility and liquidity of capital markets. In fact, the former president of the European Central Bank, Williem Duisenberg, holds this as one of the most important functions capital markets have on the banking sector.