The Banque de France has released a special issue of its Financial Stability Review on Liquidity that analyses its key determinants and looks at the challenges it poses with regard to financial stability and for central banks, the ultimate liquidity providers during financial turmoil.
It shows that liquidity is both the cause of the crisis and the symptom of far reaching changes in the financial system. The turbulence in credit and funding markets in the second half of 2007 is disturbing evidence that risk dispersion in financial markets has been less effective than expected. Investors appear to have acquired risks that they did not understand.
The liquidity crisis has rapidly become a confidence crisis: in addition to the surge in liquidity needs, the “reluctance to lend”, which is widely attributed to concerns about borrowers’ financial situation and to insufficient attention paid to liquidity management, also reflects a defensive reaction to the lenders’ own uncertainties about their own balance sheets and future liquidity needs.
The main lessons:
Securitization should not be curtailed.
Greater transparency appears as a necessary prerequisite to ensure that financial innovation does not result in greater instability.
The usefulness for central banks of having a list of eligible assets that is sufficiently diversified to address an unexpected increase in collateral demand, in order to mitigate the consequences of a financial turmoil.
Possible responses:
Most of the room for improvement rests with the private sector. This also applies to incentives, in particular to those remuneration schemes that have led to excessive risk-taking, and to credit ratings, through the revision of the rating scale for structured products for example.
A strong capital base in all segments of the financial system should restrict the impact of future liquidity shocks, especially as in an environment characterised by widespread fair-value accounting, every crisis has an immediate effect on equity capital and a liquidity crisis can rapidly lead to a solvency crisis.
The implementation of Basel II should make it possible to measure risks more accurately and precisely.
Finally, central banks responsible for systemic stability need to consider how far their traditional responsibility for the health of the banking system needs to be adapted to promote stability in the relevant financial markets.
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© Graham Bishop
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