When the rivers run dry

Mar 6th 2008
From The Economist print edition

Can bank regulators and central banks prevent future liquidity crises?



POLICYMAKERS and academics are still grappling with the causes and consequences of the credit crunch. One broad area of agreement is that ample “liquidity” encouraged the lax lending that led to bad mortgage debts, and a sudden dearth of it helped to precipitate the crisis. But what is liquidity, why does it suddenly evaporate and what can central banks and regulators do to ensure that its ebb and flow does not destabilise economies? This and much else is the subject of a special issue of the Bank of France's Financial Stability Review.*

The essence of liquidity is the ability to raise ready money to meet pressing spending needs. A firm is liquid if it has enough cash to pay its suppliers and employees and finance its investment. This funding liquidity is linked to a second facet, market liquidity—the ease with which assets can be sold without losing their value. If financial markets were complete and perfectly liquid, firms and households could always raise cash by pledging their future earnings in return. Both funding and market liquidity rely on a big enough pool of monetary liquidity to draw upon. This is a third aspect of liquidity: the amount of central-bank money flowing around the economy.

Commercial banks play a vital role in providing liquidity. They furnish ready cash to households and firms in exchange for pledges of future income, such as mortgages and loans. Banks make their profits from bearing liquidity risk (holding on to long-term pledges that cannot easily be sold), as well as from credit risk (the danger that such promises may not be kept). The two sources of risk are linked, since the greater the uncertainty about the creditworthiness of borrowers, the harder it is to sell on their loans to a third party. Banks can minimise their credit risk by vetting borrowers carefully. It is trickier to limit liquidity risk, which depends on the willingness of others to trade in markets.

Banks are not the only source of liquidity of course. Large firms can raise funds by selling bonds or shares directly to savers in the capital markets. Banks themselves have sold on bundles of their loans as securities. For a while, indeed, the securitisation boom made the old textbook role of banks seem somewhat redundant. But one of the lessons of the credit crunch is that banks are still important underwriters of liquidity when markets dry up. When investors began to turn their nose up at securities linked to souring subprime mortgages and other risky loans, banks ended up financing them.

That has been one of the main causes of the convulsions in interbank lending markets, a usually humdrum corner of the financial system which once again is showing signs of strain. In normal times, banks share their cash reserves with each other through short-term loans at interest rates that should closely track the policy rates set by central banks. Since the crisis broke, interbank lending rates have sometimes been unusually high compared with policy rates. Again this week they were signalling that banks may be hoarding liquidity—either because they are worried about their rivals' exposure to dodgy loans, or because they do not want to be caught out in the scramble for cash.

Throughout the crisis central banks have sought to iron out these kinks. At first they offered emergency lending facilities, but banks were reluctant to tap them, because of the stigma attached. To counter the strains in money markets, central banks in America and Britain decided to ease the terms of their lending to all commercial banks. Interbank borrowing costs eased over the new year after the European Central Bank (ECB) and the Federal Reserve injected $660 billion between them into money markets. If interbank spreads continue to widen, the ECB, the Fed and other central banks may have to intervene once again.


Prevention or cure?

Given these recurrent tensions in the market, how might future liquidity shocks be prevented or, at least, coped with? The proposals in the Bank of France's symposium have two broad thrusts. The first says that central banks should get their hands dirtier during liquidity crises. Andrew Crockett, a former head of the Bank for International Settlements, thinks central banks should broaden the range of collateral they accept when they supply cash to commercial banks. This would make it easier to soothe funding pressures in money markets. It would also improve market liquidity for assets eligible as security for central-bank money, to the benefit of overall financial stability.

The second, more orthodox, proposal is for tougher regulation of banks' liquidity. Holding low-yielding liquid assets is costly for commercial banks. They are reluctant to forgo profitable lending just to protect themselves against the remote chances of a liquidity shock—especially when, in a crisis, the central bank is likely to step in with extra cash. For these reasons banks should be encouraged to consider more seriously the liquidity of their loans as well as their default risk.

There is something complementary about these two proposals. The bigger the role that central banks have in offering liquidity support, the less commercial banks need to worry about their liquidity risk—which is why tougher regulation of liquidity is required. The worry is that an overly liberal collateral regime could displace private markets and their discipline; the ECB, for instance, which accepts a broad range of collateral, is believed to have taken some undesirable securities that could not easily be funded elsewhere. The offer of liquidity insurance may influence the price of the affected private-sector assets; it would also discourage private rescuers from holding liquidity by making fire-sales less likely. Why, finally, should the state offer broad liquidity insurance: isn't that what commercial banks are for?

*“Banque de France Financial Stability Review—Special issue on liquidity” (February 2008).