Mark Carney: Principles for liquid markets
Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the New York Association
for Business Economics, New York, 22 May 2008.
* * *
Over the past year, both private sector financial market participants and public sector
authorities have been preoccupied with the topic of liquidity as never before. Throughout the
financial market turbulence, private liquidity management has become tremendously
important. In parallel, policy-makers have re-examined their roles and responsibilities for the
provision of liquidity, as well as the methods they employ in doing so.
The Bank of Canada is certainly no exception. Recent events in financial markets have
prompted us to think about why, how, and to whom we provide liquidity. Historically,
discussions involving central banks and liquidity have revolved around the traditional role of
the central bank as lender of last resort - providing sufficient liquidity to still-solvent
deposittaking financial institutions so they can continue to function. However, as recent events have
made abundantly clear, policy-makers also have an interest in seeing that key markets have
sufficient liquidity. Over the course of my remarks today, I will share some of the Bank of
Canada's thinking on the principles for liquid markets.1
What is liquidity and why do central banks care?
To begin, it would be useful to set out a definition of liquidity for the purposes of this speech.
Liquidity takes on different guises within the financial system. Central bankers worry about
aggregate system macro
or liquidity, because of its connection with interest rates, credit
conditions, and future inflationary pressures. Investors are preoccupied with market liquidity,
which refers to how readily they can buy or sell a financial asset without causing a significant
balance sheet
movement in its price. Financial institutions are concerned with liquidity, which
refers broadly to the cash-like assets on balance sheets that can be used to settle payment
obligations at short notice. Further, they care about funding liquidity, which refers to their
ability to raise funds in money markets at reasonable premia.
There is a common element to these concepts. In all cases, liquidity refers to the ability to
transact in specific assets at a predictable price.2 For example, a broker-dealer wants to
know that it can transact in securities at a price approximating that on the screen. For our
purposes today, we can say that when this condition is satisfied, there is an appropriate
amount of market liquidity.
This is important because liquid markets support economic efficiency. In most economies,
financial markets are the channel through which scarce economic capital is allocated to the
most productive uses and risk is distributed among those most willing to assume it. An
efficient financial system is required for investors to receive the highest risk-adjusted returns
on their investments, and for borrowers to minimize the costs of raising capital. Since the
efficiency of the system suffers when markets function poorly, policy-makers have an interest
in promoting well-functioning markets.
A central bank further desires well-functioning, liquid financial markets because they assist in
the transmission of monetary policy. Movements in our policy interest rate set off a chain of
events, beginning with movements in a series of prices in financial markets. Improperly
functioning markets can make it more difficult to predict the effects of our monetary policy
actions, thus complicating our task. It is important to keep in mind that central bank activities
to support liquidity in specific markets or in specific institutions do not represent a change in
the stance of monetary policy, which relates to macro liquidity. Rather, they are undertaken
to address concerns about financial instability.
I want to pause on this point for emphasis. When the Bank of Canada conducts liquidity
operations (such as term repos, or "purchase and resale agreements" (PRAs) as they are
called in Canada), we are merely changing the distribution of liquidity in the financial system
by changing the composition of our balance sheet. When we do term repos, we aim to hold
fewer government treasury bills,3 which means that the private sector would hold more.4 We
are injecting liquidity where the system had generated it before, essentially by exchanging
less-liquid assets for more liquid ones. Moreover, when we roll over previous operations, as
the Bank of Canada has done recently, the scale of the liquidity injection is held constant.
The overall level of liquidity in financial markets is determined primarily by market
participants themselves. Under normal conditions, private agents supply sufficient liquidity
such that injections of central bank liquidity are not needed. Financial institutions create
liquidity by buying and selling assets to make the markets in which financial institutions fund
themselves. The financial system is liquid because institutions regularly borrow from each
other, and because they regularly buy and sell each others' short-term paper. There are
times, however, when liquidity dries up as confidence erodes in the ability of private agents
to remain in markets. When the regular process of lending and transacting slows down or
stops, the lack of liquidity means that institutions are unable to transact assets at predictable
prices at minimal cost, and financial markets become stressed. At such times, a central bank
can help restore liquidity by directly or indirectly providing liquid assets in exchange for
illiquid assets, thus helping to restore confidence in the ability of the private sector to
generate liquidity.
What has happened to market liquidity since August?
A review of recent events helps to clarify the principles of liquidity provision.
The current situation in securitization markets serves as a good example of how information
problems are at the root of market failure and how liquidity, or a liquidity shock, can cascade
through markets.
The events of last summer represented a severe shock to markets. In particular, the
realization of the potential scale of subprime losses and the associated loss of faith in
structured products and rating agencies collectively created uncertainty about - and an
associated loss of confidence in - counterparty credit quality. This uncertainty persisted
because of the extreme asymmetric information among market participants, which impaired
market makers' ability to transact with confidence and, therefore, to supply liquidity.
At the same time as the supply of liquidity was shrinking, demand for liquidity by financial
institutions was rising dramatically - for two reasons. First, the reintermediation of off-
balance-sheet assets and contingent claims expanded, and continues to expand, along with
bank balance sheets. Second, the banks' preference for liquidity increased because of
uncertainty about these types of securities. In addition, the number of potential market
participants for these securities has fallen as key investors have either disappeared - such
as asset-backed commercial paper (ABCP) and structured investment vehicle conduits - or
fled to safer havens - such as money market funds. The result has been a liquidity shock
leaving interbank interest rate spreads over expected overnight levels substantially higher (at
times, up to 90 basis points in some currencies) and considerably more volatile than
historical norms. This widening in spreads reflects both a rise in the default-risk premium -
largely related to a rise in actual and perceived counterparty risks - and a rise in the
liquidityrisk premium - largely related to increased demand for liquidity by banks related to the rise in
the amount of assets being reintermediated, and a contraction in the supply of bank-funding
liquidity. The scale of the reintermediation process may matter. For example, in Canada,
where it is less acute, interbank spreads have risen considerably less than in other
jurisdictions.
Since our current system relies on transactions among an interconnected web of financial
institutions, a liquidity shock can cascade quickly through the system. Concerns about the
solvency of one institution can lead to liquidity hoarding and dysfunctional markets. This
reduces the number of potential participants willing to transact in a market, which
undermines price discovery. As a result, it becomes less likely that markets will price assets
at their fundamental values, and the efficient allocation of resources and the distribution of
risk are thus threatened, at potentially great cost to the economy. In such circumstances, the
role of the central bank was accurately described more than a century ago by Walter
Bagehot in Lombard Street: "Theory suggests, and experience proves, that in a panic the
holders of the ultimate Bank reserve ... should lend to all that bring good securities quickly,
freely, and readily."5 Note that Bagehot did not differentiate between deposit-taking
institutions and market makers, stipulating only that the lending should be collateralized with
"good securities." However, the idea that central banks should support the functioning of a
broader range of markets through direct liquidity support is relatively new. Previously, it was
believed that central banks could adequately support markets by allocating liquidity through
banks, by altering liquidity in payments systems, or by changing the stance of monetary
policy, and that this liquidity would flow unimpeded through the financial system.
The events of last summer have challenged this consensus. The financial system will be
more stable, and the effects of monetary policy actions more predictable, if the central bank
directly supports liquidity in a wider range of markets when appropriate. Such support, which
would be expected to occur only during extraordinary circumstances, could entail expanding
the range of terms, collateral, and counterparties for central bank operations beyond what is
required for routine monetary policy operations.6
Considerations around a central bank decision to intervene
Let me elaborate on two of the words I just said: "when appropriate." How can a central bank
determine, with any level of confidence, when actions to support market liquidity are
appropriate? At the Bank of Canada, we have been thinking about the principles that would
govern any facilities that we might offer.
A central bank may want to make several judgments before deciding to lend to market
makers. In particular, it should ask itself four questions: First, is the impairment of the market
temporary or permanent? Second, will the instruments at its disposal be effective? Third,
what net benefits could come from intervention? Fourth, what are the likely costs?
In the heat of financial market turbulence, it is difficult to determine whether a situation of
illiquidity (a market impairment) is temporary or permanent. To make this determination, it is
useful to recall the Arrow-Debreu theorem of complete markets.7 In reality, complete markets
do not exist because of information costs and because not all agents participate in all
markets. A central bank must decide whether its provision of liquidity is a bridge - while
information asymmetries are resolved and potential market participants return to the market
- or whether it is a pier because there is a permanent impairment. To underscore the
distinction, consider again three aspects of recent events.
First, before the current market turmoil, many investors relied on rating agencies for credit
analysis about structured products, and this information was relatively inexpensive to obtain.
The process of financial turbulence demonstrated that rating-agency judgments were not
always reliable. Consequently, market participants are now relying more on their own credit
analysis, thereby increasing the costs for investing in structured products considerably. It will
take some time for rating agencies to re-establish their credibility.
Second, investors have discovered that there are considerable costs of accumulating
independent information on non-standardized products in order to perform, at a minimum,
risk-based analysis to check the opinions of credit-rating agencies. This is a case where
markets themselves should be able to establish standards to minimize information costs. In
the interim, the central bank or a regulatory body may help to reduce the costs of information.
The Bank of Canada has adopted high disclosure standards for ABCP that it will accept as
collateral in its Standing Liquidity Facility. This may encourage market participants to raise
their own standards. Whether they do in the end will be their decision.
Third, recent problems raised concerns over the health of counterparties - initially tied to
uncertainty about exposure to U.S. subprime mortgages and later to structured products in
general. These concerns, while material, should prove temporary before being resolved by
time and disclosure. This is why it is so important to implement immediately the best
practices for disclosure endorsed last month by the G-7 finance ministers and central bank
governors. This is a priority in Canada.
A central bank can supply liquidity to financial institutions and markets. However, it cannot
create markets where there is no private desire for them, nor can it change the fundamental
value of a security. Thus, when confronted with a market failure, a central bank should
identify the basic nature of the failure and act when it judges that a shock has distorted the
liquidity-risk premium embedded in the price of a security.
The most important potential cost of intervention is moral hazard - the risk that central bank
actions might ratify or encourage behaviours that would increase the likelihood or severity of
a future crisis. In today's circumstances, one might worry that market participants could alter
their behaviour owing to a mistaken belief that central banks would never allow any
counterparty to fail. Another concern is that in the future, banks would worry less about
market liquidity and assume that central banks would always act to provide liquidity in any or
all markets, even in cases of a very minor disruption. There could also be costs related to
distortions in markets caused by lending, or costs associated with the crowding out of private
sector counterparties. The Financial Stability Forum recommendation that central banks have
access to financial institutions' liquidity-management contingency plans has the potential to
partially limit this aspect of moral hazard. Other mitigants can be found in the principles
behind the conduct of these operations, which I will discuss in a moment.
First, one final consideration: How does a central bank know when intervention has been
sufficiently successful for it to exit? Success should not necessarily be judged on the basis of
spreads returning to predetermined levels, since fundamentals are likely to have changed
during and because of the shock that caused the turmoil. Rather, judgments about the
effectiveness of intervention should be based on evidence of better-functioning markets,
such as higher volumes, narrowing bid-ask spreads, and reduced liquidity-risk premia even,
potentially, if total risk premia do not fall. The absence of spread volatility at the end of each
quarter would be another welcome sign of improving markets. In Canada, spreads indicative
of bank funding costs (such as the spread between 3-month CDOR and the expected
overnight rate as measured by 3-month overnight indexed swaps) have fallen markedly over
the last few weeks, and are substantially below equivalent spreads in some other currencies.
The results of the term PRA auctions held by the Bank of Canada have broadly shown a
narrowing of the spread between the average yield and the expected overnight rate. In
addition, the range of the collateral being pledged shows no sign of intensifying liquidity
pressures.
Principles to guide intervention
Let me now elaborate on the five principles that we believe should guide interventions to
support liquidity in markets.
First, lending to support market liquidity should mitigate moral hazard. Such measures
include limited, selective intervention and the promotion of the sound supervision of
liquidityrisk management.
Second, interventions should be graduated. The strength of the intervention should be
calibrated to the severity of the problem, so as to guard against overreactions that could
unnecessarily raise the costs of the intervention and potentially crowd out private agents.
Third, interventions should be targeted. A central bank should attempt to mitigate only those
market failures that it is best placed to rectify. Specifically, central banks should concentrate
on liquidity disruptions which, by their nature, are not permanent.
Fourth, intervention tools should be well-designed for the job at hand; that is, lending at a
penalty rate to particular institutions is appropriate for institution-specific liquidity problems.
Market-specific liquidity problems should be addressed with market transactions at
competitive prices. Finally, when there are shortages of collateral, market transactions
should be conducted in that collateral.8
In these regards, along with traditional central bank tools, such as lender-of-last-resort
arrangements, a range of facilities is likely necessary. Each of these has distinct
characteristics suitable for different circumstances. Term purchase and resale agreements
could be offered to any financial market participant with marketable securities as the basis for
the transaction. This type of transaction would be most useful when liquidity premia in money
markets were distorted and associated with widespread liquidity problems in a particular
asset class or maturity. Term securities lending would increase the supply of high-quality
securities that could be used for collateral at times when such collateral was in short supply.
It could also allow for a direct exchange of less-liquid securities for those that are more liquid,
thus reducing the incentive to hoard precautionary liquidity. Term loan facilities could be
most useful when liquidity premia in money markets were distorted because several financial
institutions were facing liquidity shortages.
Fifth, and finally, interventions should not create further market distortions. Transactions
should, to the extent possible, take place at market-determined prices and under conditions
that are aligned with those in the market. This limits the possibility that the central bank will
crowd out the return of markets. This is an important point, on which I will expand.
Under most circumstances, central bank provision of liquidity should be priced at an auction,
where prices are set competitively, so that funding markets for the assets involved would not
normally be distorted. A well-designed auction process can help institutions avoid any stigma
associated with the receipt of central bank liquidity and minimize the possibility of confusion
about lending at rates that differ from the key monetary policy interest rate. As well, an
auction can provide a central bank with the flexibility needed to tailor the provision of liquidity
to the specific need. Auctions can also provide the central bank with valuable information
about the health of a particular market or participant. Finally, they can help to restart markets
that have stopped by providing a multi-party mechanism to determine asset prices.9
The search for symmetry
Before closing, I would like to raise one final issue. Much of the discussion about central
banks and liquidity in markets has been motivated by current circumstances, in which banks
and market makers are unable to create a sufficient level of liquidity themselves. This is a
one-sided approach to the issue. One of the reasons that the Bank of Canada's monetary
policy has been successful in anchoring inflation expectations is that we implement policy
symmetrically. Our actions are motivated as much by inflation threatening to fall below our
target as by inflation threatening to rise above it. Indeed, our recent decisions to lower our
key policy rate were motivated by a concern that future inflation was poised to remain below
our 2 per cent target.
Is a symmetrical approach to liquidity also appropriate? As I mentioned earlier, a lack of
liquidity can hamper the efficient allocation of resources and distribution of risk, and
complicate the conduct of monetary policy. It is equally true that an overabundance of
liquidity - or, more precisely, easy financing conditions for financial assets themselves - can
have similar effects. Logically, if a central bank were concerned enough to lend to market
makers in a time of scarce liquidity, would it not also want to borrow from the same
institutions in periods of excess liquidity, again assuming that such periods could be
determined with confidence?
Unfortunately, liquidity instruments such as those I have described today are poorly suited to
this task. Central banks are the stores of liquidity in our economy, and can readily supply it
by agreeing to take less-liquid assets from counterparties in exchange. Generally speaking,
central banks are not set up to operate in reverse; that is, they do not have on their balance
sheets a ready supply of illiquid assets that can be used to absorb excess liquidity held by
banks or market makers. Moreover, during an asset boom, they may have limited influence
over the confidence of financial market participants.
The principle, however, remains. Central banks and other authorities should be as concerned
about the distortions and inefficiencies created by overly easy financing conditions, rapid
credit growth, and excess confidence about future market liquidity as those created by a lack
of liquidity. So how can we achieve symmetry in our approach? In my opinion, it is worthwhile
for policy-makers to consider the promotion of macro-prudential regulations that could serve
to restrain pro-cyclical liquidity creation among banks and market makers when appropriate.
To be clear, the same tests should apply in terms of "when appropriate." There would also be
the added complication of determining where to house this regulatory authority, and how it
would be coordinated across jurisdictions. Despite these issues, this is a serious concern
that warrants closer attention.
Conclusion
The market turbulence that began last summer has eased in recent weeks. That progress,
and perhaps the coincident start of the baseball season, has prompted some to muse about
whether we are in the seventh, eighth, or ninth inning. I will not venture to be that precise, but
I would note that baseball games frequently go into extra innings, and in any event, there is
always another game and another season. It is important that we not let a sense of
complacency distract us from learning the appropriate lessons, and acting accordingly, once
the game begins again.