Press Release
What Market Risk Capital Reporting Tells Us about Bank Risk and Measuring Treasury Market Liquidity
September 17, 2003
Note To Editors

The latest edition of the Federal Reserve Bank of New York’s Economic Policy Review, featuring two new articles by New York Fed economists is available.

What Market Risk Capital Reporting Tells Us about Bank Risk

The amount of capital held by banks to cover their market risk offers new information about their market risk exposures, according to Beverly J. Hirtle. In particular, changes in an institution’s capital charges are a strong predictor of changes in the volatility of its future trading revenue. By contrast, market risk capital figures provide little information about differences in market risk exposures across institutions beyond what is already conveyed by the relative size of an institution’s trading account.

Hirtle examines the market risk capital figures reported to regulators by U.S. bank holding companies (BHCs) to assess the extent to which such disclosures provide meaningful information about bank risk.

She explains that since 1998, BHCs with large trading operations have been required to hold capital sufficient to cover their market risk: the risk of loss arising from adverse movements in financial rates and prices. The mandatory disclosure of these capital amounts--which are publicly available in regulatory reports--is designed to ensure the efficient operation of financial institutions. Disclosure gives market participants access to the information necessary to exercise market discipline on financial institutions’ risk-taking activities.

Beverly J. Hirtle is a vice president and economist at the Federal Reserve Bank of New York.

Measuring Treasury Market Liquidity

This study by Michael J. Fleming finds that the commonly used bid-ask spread--the difference between bid and offer prices--is a useful tool for assessing and tracking liquidity in the U.S. Treasury market.

According to the study, the vast liquidity of Treasuries makes them important for a range of market-related trading and analytical activities. Market participants, for example, use Treasuries to hedge positions in other fixed-income securities and to speculate on interest rate moves because they can buy and sell Treasuries quickly and with low transaction costs. The high volume of trading and narrow bid-ask spreads also make Treasury rates reliable reference rates for pricing and analyzing other securities.

Fleming observes that despite the securities’ importance, in-depth analyses of Treasury market liquidity had been hampered by the absence of highly detailed, or high-frequency, data on market activity. Recently, however, such data have become available to researchers. Measures such as the bid-ask spread, quote size, and trade size can now be used to assess and track liquidity more effectively.

Fleming’s study estimates and evaluates a full set of these and other liquidity measures for the Treasury market. It finds that the bid-ask spread serves as a good measure of liquidity. The spread is easy to understand and can be calculated quickly using real-time data. Furthermore, it is correlated with episodes of reported poor market liquidity. For example, the bid-ask spread increases sharply with the equity market declines in October 1997, with the financial market turmoil in fall 1998, and with the market disruptions around the Treasury’s quarterly refunding announcement in February 2000.

However, other measures, such as quote size and trade size, are found to be only modest tools for gauging liquidity. These measures are less strongly correlated with the episodes of reported poor liquidity and with the bid-ask spread. Moreover, trading volume and trading frequency prove to be weak proxies for market liquidity, as both high and low levels of trading activity are associated with periods of poor liquidity.

Michael J. Fleming is a research officer and economist at the Federal Reserve Bank of New York.

Other Papers of Interest

This volume of the Economic Policy Review also features a study by Edward J. Green, Jose A. Lopez, and Zhenyu Wang that describes the methods used by the Federal Reserve Banks to calculate the fees charged for their priced services. Several papers from the New York Fed’s July 2002 conference--"Economic Statistics: New Needs for the Twenty-First Century"--are included as well.

Linda Ricci
(212) 720-6143