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This chapter is from the book

1.2 Liquidity Risk—The Peso Problem of Our Time

In this book, we argue that there was a peso problem during the period leading up to the global economic crisis of 2008-2009. And we also argue that it was an extremely pervasive peso problem, touching our entire society. It is present in every market (both financial and nonfinancial), it affects most financial institutions ranging from banks to hedge funds, it has always been there, and it will always continue to be there. This latent risk factor is liquidity risk.

Liquidity risk is a term widely used now in the popular press, but the truth is that few practitioners or academics seem to understand this risk well. Perhaps not surprisingly, because until just a few years ago, there was very little work being done to analyze this risk factor. The purpose of this book is not only to provide a detailed description of the concept of liquidity risk but also to lay out how this risk affects financial institutions and thereby gets transmitted into the global economic system. We do the latter by providing an analysis of the effects of three prominent liquidity risk events in the 20th century: 1) the Great Depression of the 1930s, 2) the collapse of the asset price bubble in Japan during the 1990s—often called the Lost Decade, and 3) the global economic crisis of 2008-2009, which, at the time of the writing of this book, many would argue is still continuing.

Before we get started, we provide a bit of additional motivation to study liquidity risk by presenting a couple of puzzles. These are some of the puzzles that initially prompted us to begin researching the concept of liquidity risk and its effects on financial institutions and the global economy.

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