Financial Fragility, Capital Regulation and Bank Testing Essay

Financial Fragility, Capital Regulation and Bank Testing - Essay Example As the discussion highlights  bank mergers can reduce the cost of operation and increase scope of activities thus enabling them to control market and funding liquidity. This document examines the effects of bank mergers on market and funding liquidity and their interactions during the financial crisis. The activities of the bank influence their capacity to control market and funding liquidity. Investors prefer strong institutions that they perceive as being less risky because they are fairly stable during the periods of the economic downturn.  Ã‚  This paper outlines that liquidity risk is the risk that a particular asset or portfolio may not be exchanged in the market quickly in order to evade a loss, and it results from uncertain liquidity. Liquidity risk could either be due to the market liquidity or funding liquidity. Market liquidity is the condition whereby the assets cannot be traded in the market due to lack of liquidity in the market. The market liquidity can drain sudde nly, interlinked with instability, have cohesion across securities, co-varies with the market, and is dependent on â€Å"flight to quality†. Funding liquidity refers to ease with which traders can obtain funding for assets. The investors require portfolio security with high returns in case the market is illiquid and require return premium for an illiquid security in a situation where the entire market is illiquid. Small banks pose high risk to the investor because they may not be able to acquire funding during the periods of the economic downturn.