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International Transmission of Liquidity Shocks and Liquidity Spirals, José Manuel González-Páramo, Member of the Executive Board of the ECB explains:

The events of the past year have illustrated vividly the strength, the complexity and the rapidity of the international transmission of liquidity shocks. Clearly, underlying the international transmission mechanism is the fact that interbank markets are linked across countries by the activity and funding needs of banks doing cross‑border business on a large geographical scale and holding assets and liabilities denominated in varying currencies. Liquidity conditions in interbank markets are therefore correlated at the global level, because many of the key players are subject to common shocks.

Another dimension of the ongoing turmoil is the enhanced interaction between market liquidity and funding liquidity. Under normal market conditions, market illiquidity is typically short-lived, in particular since it creates profit opportunities for traders who, by providing extra funding liquidity, support the price discovery process and restore the smooth functioning of the market. In contrast, during a severe turbulence the disruption of the mechanisms channelling liquidity – be it through assets prices or the balance sheet of financial institutions – may also deeply and lastingly perturb the functioning of markets, ultimately creating risks for systemic imbalances.

The current episode is an example of this. Even the interbank market, which is considered the deepest and most liquid of all markets, has been protractedly “frozen”. This has happened primarily due to uncertainties as to the size and locations of losses created by the opaque transfer of credit risk brought about by complex securitisation mechanisms. Such uncertainty has heightened counterparty credit risk concerns, discouraging banks from lending to each other.

Moreover, it has brought to the fore the increased interaction between market liquidity and funding liquidity of individual institutions. Indeed, the trend among large global banks has been towards greater reliance on wholesale market sources of funding. Instead of relying on retail deposits, some banks are increasingly dependent on interbank borrowing, short and long-term debt, and, as an ultimate line of defence, on the sale of marketable securities. This has made access to funding liquidity more dependent on market conditions.

In addition, the range of systemically relevant institutions has become broader. Indeed, non-deposit taking investment banks and primary dealers play a systemic role in their crucial broker-dealer function. They perform a key role in maintaining market liquidity in a broad range of unsecured and secured markets. If they face funding liquidity constraints, market liquidity will be widely affected, with potential negative repercussions for the banking sector as a whole.

This environment poses challenges for central banks, as addressing funding liquidity shortages may require supporting market liquidity. Clearly, the nature of the turbulence matters: concerns for market liquidity itself could in principle be addressed by central bank actions, whereas central bank liquidity operations would be ill positioned to tackle individual counterparty solvency concerns. Along these lines, let me explain how central banks have responded to the challenges arising from market turmoil using a combination of operational measures and increased international co-operation.

Sub-prime crisis, liquidity tensions and central banks: One year on
Speech by José Manuel González-Páramo, Member of the Executive Board of the ECB

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Posted by jck at 8:49 am ET on October 1st, 2008 |