José Manuel González-Páramo: "Whither liquidity? Developments,
policies and challenges"
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the 28th Nomura Central Bankers Seminar, Tokyo, 14 April 2008.
* * *
1. Introduction1
Ladies and Gentlemen,
It is a great pleasure for me to be here in Tokyo. I would like to thank the organisers of this
important event, the 28th Nomura Central Bankers Seminar, for giving me the opportunity to
share with such a distinguished audience some considerations about the role of liquidity in
the recent market turmoil.
The current turmoil in financial markets has been to a very large extent about "liquidity".
Since august 2007 the different phases of the turmoil have been marked by repeated
disruptions to the traditional mechanisms of liquidity creation and transmission, both at the
aggregate and at the individual level.
Indeed, from the start of the turmoil we have experienced several episodes of contraction in
the degree of liquidity of a variety of money and credit markets. Some of these episodes
have been experienced in the market for inter-bank unsecured loans, a key component of the
money market and the starting point of the monetary transmission mechanism. Moreover,
liquidity has also dried up in the market for mortgage-backed securities and commercial
paper as well as for structured credit products. And, occasionally, poor liquidity conditions
have been reported in markets for securities historically regarded as very liquid and safe,
such as the market for banks' secured covered bonds or, even, the government bonds of
some developed economies.
Indeed, at some points in time over the last few months we have observed rises in
orderbased measures of liquidity risk for a variety of money and credit markets and declines in
traded volumes that could be explained only by the existence of severe stress.
At the individual level, liquidity shortages have taken a toll on a limited number of financial
institutions.
In my intervention, I would like to first recall some of the main issues related to liquidity and
banks' liquidity management that have played a central role during the recent market turmoil.
Second, I will briefly review developments in liquidity in credit and money markets from the
start of the turmoil. Third, I will describe some of the actions that central banks (and,
particularly, the ECB) have undertaken to mitigate disruptions to the traditional channels of
liquidity provision from the start of the turmoil. Finally, I will attempt to draw some preliminary
lessons on liquidity management and present some of the public and private initiatives that
are currently under discussion in order to reinforce the industry and regulatory framework for
liquidity risk management.
2. Liquidity issues
The multi-faceted nature of liquidity
Before moving on, it may be worth agreeing on a working definition of the term "liquidity".
Indeed, this term is often used to indicate many different things. This is a problem that has
been pointed out by several contributors to a recent volume of Banque de France's Financial
Stability Review
on liquidity issues.2 For instance, Charles Goodhart notes in his contribution
that the difficulty to define liquidity clearly is due to the multi-faceted nature of liquidity itself.
Less charitably, Jean Tirole blames the problem on the "unfortunate habit of economists" to
use this term to cover different concepts.
While some economists may argue that the specific meaning of the term becomes clear once
it is put into context (particularly whether it is used in relation to macroeconomic
developments, financial markets or single agents), it is worth striving for more clarity in the
use of the notion of liquidity. Since I realise that this may sound like a criticism to the
profession's practice, let me come clean by admitting to the same unfortunate habit of using
the same term for different purposes. Indeed, I have to acknowledge that at the ECB we refer
to liquidity to describe conditions and notions at different levels (individual, market and
economy-wide) that are distinct from each other. So, as a sign of repentance, let me try
attempt to clarify these different notions and to make the firm resolution to stick to them, at
least until the end of this speech.
In the context of the properties of an individual financial instrument, the notion of liquidity
typically refers to the ability of trading such instrument (i.e. purchasing or selling it) without
unduly affecting its price. In particular, an asset is described as liquid, thereby entailing
limited liquidity risk, if it is reasonable to assume that it can be easily sold without incurring a
loss of value.
The notion can also be used to characterise an entire market, also to reflect co-movement in
liquidity across assets. In this case, we refer to the ability to trade or liquidate positions in a
market without significantly affecting the prevailing market prices. The degree of liquidity of
the market for a financial asset is a function of a variety of factors, including: its outstanding
size; the relative size, frequency and modalities of transactions; the number and quality of
market participants; the relevance of transaction costs; the amount and quality of information
on prices, traded volumes and, more fundamentally, on the security of the asset and the
credit-worthiness of counterparties. Thus, a market in which trades can be smoothly
executed thanks to the stable presence of numerous buyers and sellers willing to undertake
large transactions at narrow bid-offer spreads is generally regarded as highly liquid.
When talking about the market liquidity, it is also customary to distinguish between
exogenous and endogenous market liquidity.3 Exogenous liquidity is related to the ability of a
market participant to execute a trade at little or no cost. By contrast, endogenous liquidity
refers to the fact that large sales over a given time period may affect market prices, thereby
giving rise to valuation losses. The degree of exogenous liquidity of a market very much
depends on many of the factors that I have just mentioned, notably its size and degree of
completeness. However, whether or not a market is exogenously liquid may vary over time
and some times dramatically. Indeed, markets that normally present some desirable
properties ensuring a high degree of liquidity may become highly illiquid under stress, as
illustrated by the experience of the very short-term money market in recent months.
Going back to the issue of the different notions of liquidity, from the start of the turmoil we
specific
have also heard reports about liquidity (or, to be more precise, lack of liquidity) of
individual financial institutions. In these reports, liquidity problems at specific individual banks
are usually referred to as equivalent to difficulties in funding their business activities. Indeed,
an additional notion of liquidity refers to the ability of a firm (not necessarily from the financial
sector):
•
to convert its assets into cash by disposing of them or borrowing against their value
in order to meet expected and unexpected obligations, or
•
to issue liabilities in order to raise funds.
The degree of funding liquidity of a firm may depend on a number of factors, notably the
amounts of liquid assets it holds and the liquidity of the credit and securities markets it relies
on for its external financing.
The last observation points to the fact that, while the different notions of liquidity (notably,
market versus liquidity funding) are conceptually distinct, they are in practice interrelated.
Indeed, some authors have developed models in which market and funding liquidity reinforce
each other, leading to the emergence of positive or negative "liquidity spirals" that may
account for some of the declines in the liquidity of markets and individual institutions
observed in recent months.4
Aggregate liquidity
Before closing the subject of defining liquidity, let me briefly recall that there is a more
aggregate
notion - that should be fairly familiar to this audience of experts on the Japanese
economy and Bank of Japan's Quantitative Easing Policy - that is often used to describe
monetary developments at the macroeconomic level. Indeed, liquidity is often used as a
synonymous for money supply. In particular, at the ECB we use the term "excess liquidity" to
indicate the existence of a stock of money relative to income in excess of the level needed to
finance non-inflationary growth in the medium term (as in the quantity theory of money).
Of course, even this notion of liquidity is not entirely unrelated to those mentioned above,
since money supply measures are derived from the consolidated balance sheet of the
banking sector. However, it is important not to confuse references to liquidity in the context of
liquidity management (that refer to the overall liquidity needs of the banking sector) with the
aggregate money holding behaviour of agents other than banks.
Market and funding liquidity risks
As I mentioned above, the liquidity of a financial instrument may vary over time, and may
become severely impaired under conditions of stress. Uncertainty about liquidity implies that
market participants face the risk that it may not be possible to execute a transaction when
they wish to do so due to the lack of counterparties. For instance, a market participant may
not be able to sell a security or liquidate a position due to lack of buyers.
Similarly, firms (but also households) face the risk of being unable to obtain enough cash to
meet their obligations. This funding liquidity risk is particularly relevant for banks since their
core business involves the maturity transformation of funds. Indeed, the traditional activity of
banks consists of providing liquidity transformation services, by collecting short-term deposits
in order to finance the provision of loans with longer maturities. As a result, banks intrinsically
face a maturity mismatch in their balance sheets that exposes them to funding liquidity risks.
Under supposedly extreme circumstances (that the experience of Northern Rock suggests
may not be that extreme), the maturity mismatch may even imply the risk of a bank run. This
may happen if large numbers of depositors perceive liquidity conditions (or solvency, for that
matter) at a specific institution as untenable and rush to withdraw their deposits in waves.
Several mechanisms and policies have been developed over time for prevention and
resolution of bank runs. These include deposit insurance schemes (whether privately or
publicly funded), regulatory and supervisory policies (e.g. on reserve and capital
requirements) and the possible recourse to emergency liquidity assistance from the central
bank (the "Lender of Last Resort" classic policy prescription).
The "originate and hold" vs. "originate and distribute" models
The characterisation of the liquidity risks faced by banks I have made so far conforms to that
of the so-called "originate and hold" business model, according to which banks create loans
to firms and households and hold them to maturity in their balance sheets. However, in
recent decades, many banks have taken advantage of financial innovation and of
developments in securitisation to progressively shift towards the so-called "originate and
distribute" model. Under this new model, banks originate loans but sell them to structured
investment vehicles (often set up by themselves) to be repackaged and subsequently sold as
asset-backed securities.
In principle, this business model is attractive for banks since it provides them with a new
source of financing to expand lending, thereby mitigating their funding liquidity risks, while
also allowing them to economise on costly capital requirements. Indeed, it has been argued
that regulatory capital arbitrage has been one of the main reasons why banks have adopted
the "originate and distribute" model.
Also from the point of view of the economy as a whole, the "originate and distribute" model
could be viewed as having many advantages. First, being capital costly, the ability to sustain
a given level of credit with a lower volume of capital enables the banking sector to reduce the
costs of credit for borrowers and favours financial development. Moreover, it may be seen as
representing a step towards more complete credit markets, thereby contributing to enhancing
the efficiency of the economic system. In addition, the securitisation of loans in principle
could reduce a secular source of vulnerability of the economies, by taking risk concentrations
associated with loan portfolios away from the banking sector and spreading them more
broadly across other sectors. As a result, the "originate and distribute" model may potentially
diminish the likelihood of the credit busts and banking crises that have historically been a
major source of macroeconomic and financial instability in many economies.
It should be noted though that, even before the outbreak of financial market turmoil, some
commentators have voiced doubts about some of the welfare-enhancing effects of the
"originate and distribute" model. For instance it has been argued that, while securitisation
certainly spreads existing risks, it may in fact encourage the creation of further risks,
particularly by relaxing the incentives for banks to screen and monitor borrowers in order to
alleviate the informational asymmetries associated with credit contracts. More generally, it
has been questioned whether the securitisation of loans may not perversely shift risk
concentrations to sectors potentially more vulnerable than those that originated them.
In this regard, I remember reading a few years ago in the Bank of Japan's Financial Stability
Review that in Japan credit derivatives based on loans originated by large and relatively
wellcapitalised commercial banks had been acquired by small regional financial institutions with
significantly weaker balance sheets. Also in the course of the current turmoil, we noticed that
some of the individual European banks affected by exposures to the sub-prime mortgage
market were relatively small institutions without the necessary technical expertise or balance
sheet strength to withstand them. In addition, for many banks all over the world, risks do not
seem to have travelled farther away than the balance sheets of their own conduits, and have
been re-internalised once the market turmoil has erupted.
While this certainly does not mean that securitisation is not welfare-enhancing, it suggests
that - in the environment of historically low returns on traditional securities and an implied
imprudent hunt for yield that preceded the turmoil - the markets for asset-backed securities
and credit derivatives may have failed to spread risks as effectively as expected and
exacerbated information asymmetries, probably as a result of their opacity and the
complexity of contracts.
More generally, the events of the last few months have revealed that, while the adoption of
funding liquidity risks
the "originate and distribute" model relieves banks from traditional and
"liquefies" the underlying assets, it increases their exposure to the risk of market illiquidity.
Indeed, this model relies on the assumption that banks are able to dispose of mortgage loans
in the form of repackaged asset-backed securities, which requires the existence of highly
liquid wholesale markets. As I will explain in the next section, over the last few months
liquidity has become severely limited in a number of markets playing a key role for the
execution of the liquidity risk management strategies of the banking sector. This has
particularly affected banks pursuing very aggressive strategies of maturity transformation,
relying on the continuing issuance of asset-backed commercial paper at short maturities.
To illustrate this point, we only need to recall the start of the current market turmoil. The
deterioration of the US sub-prime mortgage market led to the drying up of liquidity in the
markets for mortgage-backed securities. These developments led to liquidity funding
difficulties at the structured investment vehicles (SIVs) specialised in purchasing mortgage
loans from banks and transforming them into mortgage-backed securities for their
subsequent sale to investors. Liquidity funding problems at SIVs translated into analogous
problems at banks as they were no longer able to dispose of their stocks of mortgage loans,
while facing unexpected obligations arising from contingent credit lines and, in some cases,
also from the prospects of being forced to incorporate struggling in-house SIVs into their own
balance sheets. Uncertainty about future obligations among individual banks led to
significantly increased precautionary demand for liquidity, which - together with asymmetric
information - resulted in severely diminished liquidity in the money market.
3. How has liquidity been affected by the turmoil
I have anticipated already some of the developments in liquidity from the start of the current
market turmoil. Let me now review them more in detail in the remainder of this section.
As you are well aware, in July and early August a series of events led to an intensification of
the tensions in the US sub-prime mortgage market and a sharp decline in the degree of risk
appetite of global investors. Market volatility increased across almost all financial asset
classes. Stock prices declined as investors sold equities and moved funds into safe-haven
investment assets, such as government bonds. In this context, several investment funds
holding asset-backed securities suspended withdrawals from their clients. At the same time,
a number of European banks made public their direct or indirect exposures to the US
mortgage market, particularly to its sub-prime component.
In this environment, market liquidity declined for a number of assets. This was most obvious
for the markets directly related to the core of the current turmoil, namely the market for
subprime asset-backed securities (ABS). During the turmoil, the problem of illiquidity however
spread much further, first affecting other ABS and asset-backed commercial paper (ABCP),
then mortgage-backed securities (MBS) and basically all structured credit instruments, such
as collateralised debt obligations (CDO).
The market for government bonds is the only fixed income market in which liquidity has
remained fairly good. It should, however, be noted that within the euro area there has
certainly been a differentiation among different government bonds: while German Bunds
have generally remained quite liquid, the liquidity of bonds issued by countries with weaker
public finances, such as Italy and Greece, has at certain point in time been heavily impaired.
This has also had an impact on the yield spreads between these government bonds and the
benchmark Bunds, which in some cases have widened to their highest levels since the
introduction of the euro.
money markets
In the impact of the turmoil was initially felt mainly in the longer-dated
unsecured inter-bank market. It can be said that liquidity in the unsecured deposit markets
almost completely dried-up in maturities beyond 1-month (although it should be noted that
these were not the most liquid ones even in "normal" times). These frictions eventually spilled
over to the very short-term money markets (i.e. below one-week), at first in the US dollar
market where banks - particularly, from Europe - encountered difficulties in raising
shortterm liquidity.
Early in the morning of Thursday 9 August, the tensions spread to the short-term euro money
market (and also to other money markets such as the British pound and the Swiss franc
markets) triggering an exceptional fine-tuning operation of the ECB. Important factors driving
these adverse liquidity developments in the unsecured market were general uncertainty
about banks' sub-prime exposures and the scope for related write-downs resulting in ever
increasing lack of mutual confidence within the banking community. Indeed, rising adverse
selection together with increased precautionary demand for liquidity, nearly led in august
2007 to the euro money market providing a real-life illustration of Akerlof's "market for
lemons" prediction of how information asymmetries in a market with uncertainty about the
quality of goods (in this case of credit claims) may lead to a decline in trading and,
potentially, to the collapse of the market.
Interestingly, also the liquidity in the secured non-government repurchase agreement (repo)
markets was heavily impacted, as many banks no longer wanted to accept the types of
securities mentioned above (ABS/MBS/CDO) as underlying collateral in repo transactions.
As a result, only the repo markets based on government bonds remained fairly liquid, but
even in these markets the degree of price differentiation across repos secured with different
types of government bonds was larger than normal.
Another market segment that saw a partial (temporarily even severe) deterioration of liquidity
conditions is the foreign exchange swap market, which is very important for banks managing
liquidity in different currencies. In particular at times when many banks were keen on
obtaining USD liquidity, most market participants tried to swap other currencies into dollars,
while hardly any bank was willing to provide the USD funds to the extent that the market
became dysfunctional for maturities beyond 1 week.
4. Actions of central banks: What has the ECB done? What have other central
banks done?
From the start of the market turmoil, the ECB has undertaken a variety of liquidity
management operations - in some cases in coordination with other major central banks - in
order to mitigate the disruptions to those segments of the money market that are under its
direct influence.
The ECB's liquidity interventions have been accompanied by an intensification of its
communication
policy in order to stress the separation between monetary policy and liquidity
management policy.
In addition, given the rather technical nature of issues related to liquidity management and
the relative lack of familiarity of the general public with them, more intense communication
has been needed to prevent and correct occasional misunderstandings in the financial press
about the scale, modalities and objectives of our liquidity operations. In fact, observers often
fail to notice that the magnitude and nature of a central bank's liquidity management
interventions is very much conditional on the structural features of its operational framework.
Therefore, impressionistic comparisons among interventions from different central banks,
abstracting from the structural differences in their frameworks, do not necessarily serve well
the public's interest in assessing policy responses to the market turmoil.
The Eurosystem's operational framework
Thus, before explaining what the ECB has done, let me briefly outline some elements of the
Eurosystem's operational framework that have proved crucial to enable it to continue
influencing short-term money market rates in spite of the difficult situation in financial
markets.
The operational framework of the Eurosystem has been chosen with great care to function
both in normal and stressful times.5 It aims at steering short-term money market rates close
to the main policy rate in a smooth and efficient manner, with the primary aim of
implementing the monetary policy decisions
of the Governing Council of the ECB.6 It consists
of elements that are regularly employed and those that can be activated should the need
arise. In particular, this framework comprises three categories of instruments: 1) open market
operations, 2) minimum reserve requirements and 3) standing facilities.7
Even though open market operations include several different operations, the Eurosystem
has so far almost exclusively conducted two types: refinancing operations, through which
liquidity is temporarily lent to counterparties against eligible collateral and at a minimum bid
rate which signals the monetary policy, and the collection of fixed-term deposits ( use of
reverse transactions) for fine-tuning purposes, which are used to temporarily absorb
(provide) liquidity from (to) counterparties.
Moreover, banks must hold a certain amount of liquidity to fulfil their reserve requirements
(calculated as a ratio of their short-term liabilities). This requirement needs to be fulfilled on
average over each reserve maintenance period, which is approximately one month long.
The Eurosystem offers on each operating day two standing facilities which can be accessed
at the discretion of individual banks, namely a deposit facility and a marginal lending facility.
At their own initiative, banks can place liquidity in the deposit facility on an overnight basis, at
a rate which is decided by the Governing Council and is normally one percentage point
below the policy rate (the minimum bid rate in main refinancing operations), while they can
borrow overnight liquidity against eligible collateral via the marginal lending facility at a rate
which is normally one percentage point above the policy rate.
monetary policy decisions
With these instruments, the Eurosystem implements the of the
Governing Council of the ECB. More precisely, by using these instruments the Eurosystem
manages liquidity conditions in the euro area money market so as to steer very short-term
interbank money market rates as close as possible to the policy rate - the minimum bid rate
- decided by the Governing Council.
Eurosystem's open market operations during the financial market turmoil
At times of increased liquidity risk at longer maturities, a key concern of central banks is to
support the re-establishment of the smooth functioning of the very short-term money market.
This is a precondition for ensuring the transmission of the monetary policy impulses to the
economy.
In the context of the current market turmoil, the primary aims of the ECB's liquidity
keep the overnight rate as close as
management policy have been: (1) as in normal times, to
possible to the minimum bid rate; (2) the ECB has endeavoured to ensure the smooth
functioning of the money market, also at term maturities, by facilitating access to liquidity to
solvent credit institutions, thereby helping them to meet their liquidity needs in a smooth
manner. By doing so, the ECB has intended to contribute to re-establishing confidence
among market participants and to safeguard financial stability and the appropriate functioning
of the monetary policy transmission mechanism.
In line with these aims, during the recent period of financial market volatility, the Eurosystem
has supported banks' access to liquidity and the general functioning of the money market by
implementing various measures, which can be summarized as follows.
First it has made some relatively small adjustments to the modalities of its supply of euro
liquidity by adjusting
•
the distribution of liquidity supplied to the market within the reserve maintenance
period without, however, increasing the average quantity of the liquidity supply
(front-loading policy), and
•
the way in which the liquidity is allotted to the banking system, i.e. it has increased
the maturity of its refinancing operations, it has augmented the frequency of its
finetuning operations, and it has occasionally applied different tender specifications.
Box 1
Adjustments to open market operations during the recent turmoil
Distribution of liquidity supply
The main reason for adjusting the distribution of liquidity supply during the turmoil was the
perceived change in the pattern of the demand for liquidity within the maintenance periods.
The financial turmoil showed that interest rates were no longer necessarily linked to liquidity
conditions on the last day of the maintenance period, as banks did no longer regard reserve
holdings on different days of the maintenance period to be substitutes (contrary to the
martingale hypothesis).[a] Indeed, in the first days of the turmoil, interest rates rose
significantly because they were driven mainly by precautionary motives. Counterparties were
not only reluctant to lend on unsecured terms, but they also feared being confronted with
unexpected liquidity needs and, as a consequence, preferred having liquidity buffers.
Therefore, to avoid upward pressure to overnight rates, the supply of liquidity had to be
brought forward within the maintenance period.
As a result, the ECB accommodated banks' preference for front-loading their reserves during
the reserve maintenance period, by increasing the liquidity supply at the beginning of the
period and reducing it later in the period.
More specifically, since the start of the turmoil and after the first "fire-fighting" fine-tuning
operations conducted in August, the ECB has achieved this frontloading by adjusting its
regular provision of liquidity in the regular main refinancing operations so as to provide larger
amounts at the beginning of the maintenance periods, while it has provided correspondingly
less towards the end of the maintenance period, so that in total, over an entire maintenance
period, the supply of liquidity has remained unchanged. In addition, since November,
whenever notable downward pressure on the overnight rate started to appear, it has also
conducted liquidity-absorbing fine-tuning operations with maturities of between two and five
days.
Through this policy of front-loading, the ECB has allowed credit institutions to fulfil their
reserve requirements relatively early in the maintenance period, but, at the same time, it has
kept unchanged its average supply of liquidity over the maintenance period. Such an
approach is in line with the Eurosystem's aim to provide to the banking system, over each
maintenance period, the exact amount of liquidity needed to fulfil their liquidity deficit, which
is given by the reserves requirements and the net liquidity-absorbing autonomous factors.
Adjustment in the allotment of liquidity over the reserve maintenance period
In order to support a normalisation of the conditions of the money market, the ECB has
adjusted the way in which the liquidity is allotted to the banking system. This has been
achieved though several actions.
First, as just mentioned, the ECB has made more frequent use of fine-tuning operations than
in "normal" times (both in order to inject liquidity in addition to that provided in the main
refinancing operations (MROs) and to absorb excess liquidity), as needed in order to keep
the very short term interest rates close to the minimum bid rate in the light of the highly
unstable and unpredictable liquidity demand.
Second, the Eurosystem has increased the share of refinancing provided via three-month
longer-term refinancing operations (LTROs), and reduced the share provided via the
oneweek MROs. Accordingly, the total amount of outstanding refinancing has remained
unchanged, while the average maturity has been extended, thereby contributing to reduce
the future liquidity needs of the banking system.
- More specifically, in addition to the regular monthly LTROs, two supplementary
LTROs with a maturity of three months were carried out in August and September
2007. The Governing Council decided to renew these operations, with slightly
amended sizes, when they matured in late 2007 and in early 2008, and has since
announced the renewal of the upcoming maturities in May and June 2008.
- Besides, on 28 March 2008 the Eurosystem decided to further enhance the
provision of supplementary longer term refinancing, and announced two
supplementary six-month LTRO of a pre-set amount of EUR 25 billion, to be settled
in April and July 2008.
As a result, the share of the total refinancing provided through LTROs is currently 66%, more
than double the share (30%) prior to the financial turmoil.
Third, a special tender procedure with full allotment has been applied on two occasions.
- Such procedure was first applied for the fine-tuning operation on 9 August, when it
was deemed more efficient to leave it to the market to determine the exact allotment
amount, given the large degree of uncertainty.
- A more muted variant of a fixed rate tender with full allotment was applied in the
MRO on 18 December. This operation had an exceptionally prolonged maturity of
two weeks so that banks could cover their liquidity needs over Christmas and the
days around the year-end in advance of this difficult period. This muted variant
consisted of pre-announcing a commitment on the ECB's side to satisfy all bids at or
above the weighted average rate of