Liquidity Crisis in Bangladesh

Topics: Stock market, Central bank, Stock exchange Pages: 32 (11259 words) Published: May 9, 2012
2. An Overview on liquidity crisis:
Demirguc-Kunt and Levine (1996), Singh (1997) and Levine and Zervos (1998) find that stock market growth plays an important role in predicating future economic growth in situations where the stock markets are active. The arguments of Demirguc-Kunt et al. (1996) indicate that economies without well-functioning stock markets may suffer from three types of imperfections: first, opportunities for risk diversification are limited for investors and entrepreneurs, second, firms are unable to optimally structure their financing packages and third, countries without well functioning markets lack information about the prospects of firms whose shares are traded, thereby restricting the promotion of investment and its’ efficiency.

The proponents of stock markets emphasize the importance of having a "developed" stock market in enhancing the efficiency of investment. A well-functioning stock market is expected to lead to a lower cost of equity capital for firms and allow individuals to more effectively price and hedge risk. Finally, stock markets can attract foreign portfolio capital and increase domestic resource mobilization, expanding the resources available for investment in developing countries. Recognizing the importance of stock market on economic growth, prudential authorities such as World bank, IMF and ADB undertook stock market development programs for emerging markets in developing countries during 80s and 90s and the emerging stock markets have experienced considerable development since the early 1990s. The market capitalization of emerging market countries has more than doubled over the past decade growing from less than $2 trillion in 1995 to about $5 trillion in 2005 (Yartey, 2008). As a percentage of world market capitalization, emerging markets are now more than 12 percent and steadily growing (Standard and Poor, 2005). The government of Bangladesh also undertook the Capital Market Development Program (CMDP) supported by the ADB on 20 November 1997. The CMDP aimed to broaden market capacity and develop a fair, transparent, and efficient domestic stock market to attract larger amounts of investment. The assessment of the growth of Bangladesh stock market over the last few years thus remains an important empirical issue.

2.1 Liquidity crisis

Other synonyms of liquidity crisis may be stated as liquidity squeeze, credit crunch, market illiquidity A liquidity crisis is a shortage of cash and other immediately available funds to meet financial needs such as repayments or urgent spending or funding. It can affect banks, financial markets, businesses, States or even the whole economy bringing a domino / systemic crisis (a worldwide crisis that affect the whole system)

2.1.1 Liquidity crisis in different sector:

a) Banking liquidity crisis

In the banking system, a general liquidity crisis happens when most key banks in the world (or at least in a large economic zone) experience a shortage of immediately available customer deposits and other monetary resources (interbank money market borrowing, central bank loans...) to finance the loans and other assets in their portfolio (or to face depositors withdrawals or payments).

The crisis can reach the whole banking system (systemic crisis, see below) when no bank lends to any other, either because of a lack of funds ... or a lack of trust. In that case the interbank money market gets inactive or offers extremely high interest rates. This was seen as one of the aftermaths of the famous subprime crisis already mentioned above.

In such cases, unless the central bank injects liquidity massively the banks that survive have to restrict their lending to individuals and businesses (liquidity squeeze / credit squeeze / credit crunch). This can stall the economy.

b) Liquidity crisis in financial markets.

In financial markets, a situation of illiquidity strikes when buyers or sellers cannot find counterparts for...
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