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The depth, scope, and persistence of the financial turmoil is in significant part attributable to broader concerns about the liquidity of money markets, Federal Reserve Vice Chairman Donald Kohn said raising the possibility of giving securities firms permanent access to central bank loans, as long as regulators tighten oversight of the companies.
Market participants must thoroughly reassess the market-liquidity assumptions that underlie their existing risk-management practices, Kohn said.
“Perhaps most important, market participants must reassess their assumptions about the stability of secured funding in circumstances in which the liquidity of the markets for the underlying collateral becomes impaired”, he said. “That reassessment is especially important because in recent years market participants have been funding growing volumes of relatively less liquid assets though secured financings in the money markets.”
The primary responsibility for reassessing and strengthening the management of liquidity risk appropriately rests with market participants themselves, he said. But prudential supervisors, working with central banks, should carefully review the practices of regulated entities.
Central banks, however, should consider how to adapt their facilities to help these institutions mobilize their global liquidity in stressed market conditions and apply it to where it is most needed.
“It is possible that over time, major central banks could perhaps agree to accept a common pool of very safe collateral, facilitating the liquidity management of global banks”, Kohn said.
“I believe experience to date has taught some lessons regarding the management of liquidity risk by market participants and the design of central bank liquidity facilities that will prove durable”, he said. However, until the market turmoil fully abates, we run some risk in trying to draw lessons from recent experience, he continued.