From illiquid financial instrument to market distress ? selected institutional circumstances of the credit crisis

Abstract

The recently observed credit crunch is yet another market disruption confirming the critical role of liquidity in the financial system. It is however the first time that illiquidity of a single financial instrument has led to illiquidity of a significant part of the financial system. Although the credit crisis had limited effect on the Polish economy, thorough understanding of the underlying mechanisms is necessary to properly monitor the financial stability in the future, as the Polish financial system gets more integrated into the global one. The article discusses selected mechanisms of the crisis and concentrates on the characteristics of the financial markets that led to the sudden spill-over of the turbulence in the global financial markets. The paper highlights the two types of risk, which were underestimated in the past, but played a major role in instigating and magnifying the recent crisis. The first one is the liquidity risk, which may undermine the reliability of the mark-to-market valuation and produce extreme price volatility once the confidence in such valuations is eroded. The second one is the counterparty risk which results from concentration of market turnover in the period of rapidly growing volumes of derivatives traded in the market. The article leads to the conclusion that the lack of transparency and liquidity on the credit risk markets triggered the severe financial crisis in the global financial market. The analysis of the liquidity risk and the counterparty risk illustrates that some institutions became crucial for the functioning not only domestic but also global markets.