Sir Andrew Large: Financial stability - managing liquidity risk in a global
system
Speech by Sir Andrew Large, Deputy Governor of the Bank of England, at the Fourteenth City of
London Central Banking and Regulatory Conference, London, 28 November 2005.
* * *
1. Introduction
Much is written today about the search for yield. Much is said about the factors that underlie it:
accommodative monetary policy; savings gluts; and financial engineering which multiplies the
opportunities for increasing leverage. And much, too, is said about new instruments, such as those
involving credit risk transfer, or new players, such as hedge funds, that trade them.
However, my main concern today is not with the search for yield as such, nor with market innovations
or new players. Rather, it is with the financial vulnerabilities to which they could give rise, and what
can be done to mitigate those vulnerabilities.
Because it seems to me that the search for yield also highlights some less benign aspects of today's
financial system: the opacity of markets in some new instruments; the difficulty of knowing the real
value of assets and contracts; reliance on models that have not been tested in the full range of
economic conditions; the uncertainties over behaviour of new participants in the markets should
events turn adverse; and the difficulty we have in judging just how deep markets will prove to be
should a substantial number of investors decide simultaneously to try to realise their investments.
On a more practical level, there is no lack of evidence that things can and do go wrong. We have
recently seen lack of operational discipline in some financial markets leading to documentation
backlogs and to uncertainty over the enforceability of transfer of risks. We see more relaxed lending
criteria in the LBO market, increased reliance on potentially illiquid instruments in trading strategies,
and questionable quality of some IPO's. We have seen specific examples of significant downgrades or
outright failures such as GM/Ford, AHBR and, more recently, Refco and Delphi.
One reaction to these episodes is that they show the market doing its work and are testimony to the
effectiveness of market discipline. The fact that the financial system has coped with these problems
may well also be testimony to the strengths of that system.
On the other hand, might not these episodes be a potential sign that all is not well? The question is:
are vulnerabilities mounting, and will they one day crystallise when a bigger shock arrives that the
market simply cannot absorb?
The fact is, we just don't know. And that is why we need to be particularly vigilant.
Such questions lead me to think about issues relating to liquidity. If a period of market stress
materialises, triggered by a sharp snap back in prices, it is critical that the financial system should be
able to meet a temporary increase in the demand for cash without precipitating, in the vernacular, a
'market meltdown'. Liquidity is therefore the focus of my remarks today. By liquidity I mean two things.
First, institutional liquidity: the continued ability of individual financial institutions to meet claims as they
fall due. And second, market liquidity: the depth of markets for the sale or loan of assets or the
hedging of the risks that underlie those assets.
To set the scene, it is perhaps worth reflecting on how liquidity needs and processes may amplify the
risks of instability-that is, their ability, in stressed conditions, to disrupt the functioning of the financial
system generally, and the banking and payment systems specifically.
The traditional route arises from the banking system's role in maturity transformation between short
term deposits and long term loans. Managing this mismatch whilst maintaining the confidence of
depositors is the essence of the business of banking. However, the presence of this maturity mismatch
means that individual banks are by their nature fragile. The connections between banks, and the
potential for doubts about one bank to spread to others, mean that the failure of one bank to manage
its mismatch can potentially put at risk the financial system more widely. Bagehot in 1873 summed up
this link between maturity mismatch and systemic risk:
'Of the many millions in Lombard Street, infinitely the greater proportion is held
by bankers or others on short notice or on demand; that is to say, the owners
could ask for it all any day they please: in a panic some of them do ask for
some of it. If any large fraction of that money really was demanded, our banking
system and our industrial system would be in great danger.'
In Bagehot's time, the role of the Bank of England was to act as guardian of the reserve of bullion that
underpinned the credibility of the whole banking system. The technology may have changed, but in
essence the role of the Bank today is one that Bagehot would recognize. Central bank money is the
ultimate settlement asset. And banks still demonstrate their ability to meet depositors' demands for
repayment by holding a sufficient stock of high quality securities against which central banks-and in
normal circumstances the markets-will lend. Confidence in the modern financial system is therefore
without
underpinned by the preparedness of central banks to lend against such high quality security
question.
Central banks have, therefore, a keen interest in developments that affect the demand for and supply
of liquidity. It is not surprising that they try to limit the likelihood of events that might lead to excessive
increases in demand for liquidity or constraints on its supply, and also try to have in place the
operational apparatus to respond to such developments, if felt necessary, at minimum cost.
The traditional sources of liquidity risk for banks are unusually heavy demands from depositors for
repayment and from their customers to draw down pre-committed funding. Today's environment
encourages us also to recognise disruption to markets as a potential trigger for such extraordinary
demand. If you think about the expansion of markets in which banks participate, both as principals and
as intermediaries, and the fact that at times of stress investors would be likely to place a premium on
"safe" assets and ultimately on cash, then it soon gets you back to thinking about the robustness of
arrangements that enable banks to satisfy unexpected spikes in cash demand, perhaps in unexpected
locations. Markets rely on this in order for them to function with confidence.
2. How has the world changed?
I said that Bagehot would recognise the modern role of central banks. However, the firms that
comprise the financial system are much altered since his day. So I should like to make a few
observations both about how this has affected firms' own liquidity management, and crucially how the
public authorities might react.
Firstly, concentration in the global financial system has increased, with a relatively small number of
global firms-banks and non-banks-representing a significant fraction of the system. These firms
often employ centralized liquidity management. And they are increasingly strongly interconnected,
within and across borders, and via new markets for risk transfer as well as more traditional channels.
Participation in risk transfer markets does more than just create new links between firms: it also
creates a new potential demand on firms' liquidity in the form of margin calls. Moreover, this additional
demand may be positively correlated with other liquidity risk that firms face in the event of market
stress.
Secondly, there are certain features of the prevailing financial and economic environment that give us
pause for thought. Market prices are at historically unusual levels: real and nominal returns on risk free
assets are low and credit spreads are tight, both in traditional and structured products. It is of course
hard to say definitively the extent to which today's markets are merely reflecting changed
fundamentals. But it is quite possible that some investors have unwittingly taken on higher levels of
risk in pursuit of what they would consider to be "normal" levels of return. And it is certainly prudent to
plan for the possibility of a sharp reversion of prices to historically more normal levels (or even beyond
them, given the tendency of markets to overshoot). There could be a period of impaired market
liquidity during any such correction. One could imagine a number of potential catalysts for such a
correction, ranging from a geo-political event to some form of major operational disruption.
The Bank concurs with the widely held view that the growth of markets in risk transfer should
depth
contribute to greater financial stability, by allowing a more efficient dispersion of risks. But the
and reliability of the more recently developed markets in risk under stressed conditions has not yet
been fully tested. Moreover, risk transfer markets can, and probably at present do make the ultimate
destination of risks more opaque. This hampers our ability to assess the overall stability of the financial
system, and, potentially, to react effectively in a crisis.
3. How have firms reacted to these changes?
The banking industry has, not surprisingly, responded to these changes by paying greater attention to
liquidity risk management. And, as well as day-to-day management, banks have given more
consideration to how they would cope with extreme or 'tail' events.
Banks have developed, or are at least in the process of developing, sophisticated scenario analyses,
and are assessing the contingency arrangements that would be required to respond to these
scenarios. It is certainly encouraging to observe the determination with which many banks are
addressing liquidity risk, and it is at the same time noteworthy how efficiency drivers have led many
banking groups to take a more centralised approach to liquidity management.
But, despite the progress that banks are making in addressing liquidity risk, the framework that
underpins their contingency plans makes a number of assumptions, particularly regarding access to
funding markets. There seems, for example, to be a widespread view that, whatever has happened to
a firm's access to wholesale unsecured funding, it will be able to borrow secured against good
collateral. Lying behind this is probably an expectation that national authorities, and in particular
central banks, will be ready to provide liquidity against good collateral in the event of the failure of one
or more of the markets for secured borrowing.
Banks are also giving greater thought to the impact of an extreme event on the value of collateral and
the proportion of that value that can be borrowed, as well as the sale value of any assets that they
might consider liquidating. The assumptions here might prove to be optimistic particularly in
circumstances such as those seen in 1998, when extreme events led to one-way markets and a
vicious circle in which asset price falls did not lead to increased demand but rather to further increases
in supply. It is for reasons such as these that the contingency planning that firms put in place needs to
be sufficient.
Banks have also placed increased emphasis on identifying potential sources of liquidity shocks.
Products which entail the posting of margin, such as derivatives, can result in significant calls on
liquidity.
4. Policy responses
So what gaps does this leave, and what policy responses are therefore needed on top of firms' own
actions? There is scope for further work by the private sector on improving liquidity risk management.
But there are also a number of issues for public authorities to address.
The preparations that firms make are influenced by regulation. When balancing the costs and benefits
of measures to mitigate risk, banks naturally have regard to the interests of their own shareholders.
But one of the roles of, and indeed justifications for, regulation is to ensure that firms also take
sufficient account of the interests of others who would be adversely affected by their failure: their own
borrowers and depositors, for example, but also the customers of other banks that would suffer losses
if a particular bank were to get into difficulties. In other words, one purpose of regulation is to align
private choices with public welfare maximisation.
capital
Hitherto, public authorities have placed much emphasis on requirements as a way of achieving
this reconciliation. Indeed, one reason for imposing capital requirements is to limit the risk of liquidity
problems, by giving the market a level of assurance over the solvency of a firm. But this emphasis on
capital has perhaps overshadowed the importance of direct liquidity requirements. Analytically, liquidity
is a more difficult area. But arguably the case for prudential liquidity requirements in some form is just
as strong as for capital. Liquidity cushions are a first line of defence: in times of stress they can buy
are
time, and where organisations solvent they can help to prevent liquidity problems turning into
solvency ones. I will return to this later.
But besides regulation, the public authorities-specifically central banks-have a crucial role as the
ultimate providers of liquidity. They therefore need to ensure that they are properly equipped to carry
out this function.
Avoiding or resolving liquidity problems is not just a matter of ensuring adequate aggregate liquidity; it
also means ensuring that liquidity can be, and is, distributed effectively round the system. This was
illustrated by the events of 9/11, when the US money market was temporarily unable to distribute
liquidity to the banks that needed it. On that occasion, for example, the Federal Reserve injected
considerable liquidity, more than $100bn, via a combination of daylight overdrafts, discount window
lending, and general market support. 9/11 also highlighted the importance of central banks being able
to lend directly to solvent institutions facing a liquidity crisis. Under stressed conditions, and with the
associated uncertainties, attempts by a perfectly sound bank to borrow unusually large amounts from
the market, even against good quality collateral, have the potential to raise, or exacerbate, doubts
about that bank's solvency. But a solvent bank that is in need of liquidity can safely reveal its need to
the central bank without precipitating a crisis in market confidence; uniquely, the latter is not at risk of
experiencing a run, and so will not overreact in an effort to protect its own balance sheet.
In many countries 'automatic' direct liquidity provision against pre-defined acceptable collateral is
hard-wired into the operational framework for monetary policy implementation through so-called
'standing facilities'. In the UK we are broadening the range of firms to whom we can supply liquidity in
this way. This implements Bagehot's prescription for mitigating systemic risk, that the central bank
should as far as possible make clear in advance its preparedness to provide liquidity in stressed
conditions. Referring to the central bank, he puts it thus:
'The holders of the cash reserve must be ready not only to keep it for their own
liabilities, but to advance it most freely for the liabilities of others. They must
lend to merchants, to minor bankers, to "this man and that man", whenever the
security is good.'
The picture becomes more complex in the case of global firms that manage liquidity centrally. Such
firms have liquidity needs in multiple currencies and locations. They may find it costly to hold enough
liquid assets in every market in which they operate, and hence potentially face a mismatch between
the location of their liquidity needs and that of their liquid assets.
In response to this several central banks, notably those in Switzerland, Sweden, the UK, and the
United States, have taken steps to allow the cross-border use of collateral in some or all of their
routine lending activities. Others have taken the alternative route of attempting to reduce collateral
costs for banks, and hence relax potential constraints, by accepting a range of less liquid and
nonmarketable assets, while still controlling the credit quality of the assets involved. For example, the
Eurosystem accepts a wide range of non-sovereign debt securities, including corporate bonds and
asset-backed securities. The European Central Bank's proposed 'Single List' will also include certain
bank loans; indeed these are already eligible in some member countries. Similarly, the Fed has
broadened the range of collateral accepted at the Discount Window.
A working group commissioned by the Basel-based CPSS (Committee on Payment and Settlement
Systems) in 2004 has examined whether existing arrangements would prove adequate in an
emergency. It would appear that some of the infrastructure required to facilitate more extensive
crossborder use of collateral is already in place: links between securities settlement systems, for example.
Nevertheless, central banks may need to put in place more cooperative and coordinated policies, such
as the establishment of a framework for information-sharing.
When risks do crystallise it is imperative that central banks, along with regulators and ministries of
finance, are well prepared so that they are able to respond in an effective manner. The CPSS working
group looked at preparations that are needed in order to be able to make effective use of existing
infrastructure in a crisis. But it is equally important that central banks and regulators be in a position to
make the decisions necessary for resolution of a crisis, both individually and, when needed,
collectively.
This entails gathering data and intelligence on firms and markets, sharing it appropriately amongst all
relevant public authorities, understanding the systemic conjuncture, and setting up national and
international frameworks for coordination of decision making. I could give an entire speech about
questions in these areas, and current and potential initiatives to address them1. However, today I
would like to return instead to the subject of liquidity regulation.
The potential willingness of the authorities to supply discretionary-as opposed to routine-liquidity in
a crisis is likely to give rise to moral hazard, because in the real world, faced with incomplete
information, it is difficult or impossible to identify ex ante a 'pure' liquidity crisis. By, for example,
relaxing normal criteria on collateral quality authorities may move from the injection of liquidity to what
is effectively the provision of risk capital. Firms may then be inclined to tailor their risk-taking to their
own assessment of the probability of intervention, while at the same time the incentive for firms to hold
adequate buffers of liquid assets is likely to be reduced. The gap between the amount of liquidity that
a firm will choose to hold, and the optimal public choice will then widen. It is not surprising, then, that in
most jurisdictions firms' liquidity management is subject to standards imposed by regulation.
Intervening in this way requires that the authorities be able to answer some difficult questions. There is
the question of calibration: how much liquidity is 'enough' for any given firm? In other words, what is
the optimal public choice of liquidity buffer? And for how long should a firm be expected to be able to
survive without outside help? This is a much more difficult question for liquidity buffers than for capital,
as in the case of liquidity it is not sufficient merely to analyse the structure of a firm's assets and
liabilities. The firm also has to take account of the possible ways in which its counterparties and
creditors may behave in a crisis. Moreover, in a liquidity crisis, there is feedback from the actions that
a firm takes to meet liquidity needs-selling assets for example-to the market's perception of its
solvency and hence to the size of those very liquidity needs. Furthermore, it is arguable that buffers
should vary to some extent with the level of risk that a firm brings to the financial system. Firms that,
for example, are relatively large or opaque, or have more extensive connections to other parts of the
financial system might be expected to meet higher standards under such a regime.
The impact of liquidity standards on a firm's relationship with its central bank, both in normal times and
in crisis, also has to be considered. In many countries, the UK included, firms need to obtain central
bank money in order to make payments to other banks in the real time gross settlement system and to
settle delivery versus payment securities transactions. The ability to obtain central bank money-
liquidity-depends at all times on having access to sufficient quantities of high quality collateral. And
such collateral is of course amongst the best forms of insurance against liquidity problems. So the
require
extent to which prudential liquidity standards firms to hold collateral, and the precise way in
such requirements are calibrated, have a direct impact on the economics of their participation in
payment systems and in central bank operations to implement monetary policy.
The structural and conjunctural developments that I described earlier are most material to these
questions. On calibration, for example, greater inter-linkages between firms mean that the external
costs of failure-the costs that are not borne by the firm itself and are therefore unlikely to be taken
into account in its own planning-are greater. If markets on which firms now rely for some of their
We also obtain a great deal of additional information in the course of our own market operations, through our involvement in
payment systems and other infrastructure, through our counterparties and contacts, and in other ways. Intelligence of this sort
allows us to understand the environment-the products, techniques, and markets-in which firms operate and how they and the
markets in which they trade may behave in times of stress. It therefore supports analysis of how stress might spread and how
the authorities can most effectively respond; and it helps to identify the appropriate channels for communicating this response.
But analysis from intelligence can also provide early warning of symptoms of actual or incipient stress; for example, a high
degree of leverage coupled with crowded trades in markets that can be illiquid.
The authorities then have time, where appropriate, to publicise any concerns so that firms can take action to prevent the risks
from crystallising, and factor them into stress tests and scenario analysis. We provide such analysis regularly in our Financial
Stability Review. And were a crisis to develop, an understanding of the 'systemic conjuncture' is also required to enable the
authorities to assess on a continuing basis the likely systemic impact, and to choose an appropriate policy response.
As well as information exchange, strong co-ordination of decision making between central banks, regulators, and ministries of
finance, is likely to be essential for effective crisis management. This is true both at a domestic and an international level. A first
step is for the relevant national authorities to have clear, well established, processes for decision making and for communicating
externally, and to ensure that these processes are well understood by all parties. In the UK, HMT, the Bank and the FSA have a
published Memorandum of Understanding (MOU), established in 1997, which sets out a high-level framework for co-operation in
the field of financial stability.
Although there is no such agreement at an international level at an equivalent level of detail, a 'Memorandum of Understanding
on co-operation between banking regulators, central banks, and finance ministries of the European Union in Financial Crisis
Situations' was signed earlier this year. It is fair to say, however, that this represents only a first step.
Finally, if the authorities decide to take measures to mitigate the systemic impact of a crisis-for example through emergency
liquidity injection of one sort or another-it is vital that the central bank, supervisor and ministry of finance act, and are seen to
act, in a decisive and joined up way. In the UK, the MOU provides for strategic management of a crisis at meetings of a
'Standing Committee', the members of which are senior representatives of HMT (who chair the meetings), the Bank, and the
FSA.
liquidity became fragile, then, all else being equal, firms would be more vulnerable to liquidity
problems.
This argues for the authorities in all jurisdictions to review whether the liquidity standards that they
currently impose are still appropriate, given the nature of firms and their activities. But globalization
also means that there is a case to look again at consistency of liquidity standards across jurisdictions.
As central banks or regulators we are each seeking to achieve a high level of soundness in our
respective financial systems. But the soundness of any of the global firms that are a major part of
those systems is a function of the standards imposed on the group and its major subsidiaries in many
jurisdictions.
None of this necessarily argues for full harmonization of liquidity standards in the way that capital
standards have been harmonized. But each jurisdiction inevitably relies to a degree on liquidity
standards imposed elsewhere to ensure the soundness of potentially systemically significant firms.
Central banks and regulators need at least, therefore, to come to a common understanding of what
they are individually seeking to achieve with liquidity regulation. Are we, for example, seeking with
such regulation to limit the likelihood of crisis, or the impact of a crisis should one arise, or both? What
sort of liquidity problems are envisaged in the regulation? Most importantly, we should seek a common
understanding of the dividing line between ex ante insurance, and ex post resolution.
5. Conclusion
This is my last Financial Stability speech as Deputy Governor and I would like to leave you with
several thoughts.
First, I can't help feeling that it is at times such as this, when we have a relatively benign environment,
that we should seek to address difficult and contentious issues of the kind I have been discussing. It is
certainly true that the risk transfer markets and the financial system have coped, with remarkable
success, and with few signs of instability, with the various events and shocks in recent years. But we
need to be sure that we are not complacent in placing trust in the ability of the financial system to
continue to absorb shocks smoothly.
Second, policy makers have found it hard to discuss lender of last resort issues because they can so
quickly raise the spectre of moral hazard: by giving too many clues to their likely response to
instability, policy makers fear undermining market discipline and so making crises more likely. Equally,
public policy makers should recognise the distinction between clarity about processes-where
transparency to my mind can only be positive for confidence-and transparency about how decisions
might be reached in a particular case, where constructive ambiguity remains important as a
mechanism to reinforce market discipline. On the other side of the fence, banks and financial
institutions have made impressive strides in coping with these realities, but may be reluctant to move
explicitly to transparent best practice standards. Maybe this is for fear of giving up competitive
advantage, or maybe it is a fear that regulators might seek to impose unwelcome prescription in how
they manage liquidity risks.
Third, my message today is that both public and private sectors would be wise to overcome these
inhibitions in the interest of developing mechanisms for providing liquidity in a manner that is fit for
purpose in today's globalised world, and recognises the new environment and systemic conjuncture.
In the case of private entities, they, to my mind, could show greater enthusiasm and leadership in
coming up with sets of best practice standards, in the knowledge that failure in one institution could be
severely damaging for others.
I say this in the knowledge that, in the case of the public authorities, debate on all these issues is
rising rapidly up the agenda, not just in London where the FSA and ourselves have a shared
responsibility, but in other major financial centres as well. Progress on understanding all of these
difficult issues can be made through ongoing informal dialogue amongst the central banks and
regulators that are most concerned with our largest financial institutions. I am encouraged that there
are a number of informal groups who are undertaking work in this area. These feed into official groups
such as the Financial Stability Forum where the vital connection between the public and private
sector can be made.
These are stimulating and fascinating issues, and I confidently expect them to occupy people's minds
for many years to come.