lending positions, particularly in the inter-bank market. These actions create direct funding liquidity needs at other market participants (channel 5)”.<sup>14</sup> 16. Banks might organize their global liquidity management in different ways but, in general, they can opt for a completely centralized approach with the head office managing liquidity for the whole company in every currency. Alternatively, they could follow a decentralized model where operating units are assigned responsibilities for managing their own liquidity, subject to centrally set limits and frequent reporting to the head office. Using a different approach, the bank could also decide to centrally manage liquidity in the home currency while foreign subsidiaries or branches manage their liquidity in the currencies in which they operate.<sup>15</sup> Irrespective of the liquidity management model adopted, information must be readily available and current, supported by adequate Management Information Systems (MIS) for Sr. Managers and their Boards of Directors.<sup>16</sup>

# 17. One of the lessons of the present financial crisis is the importance of paying enhanced attention to liquidity issues. As mentioned in the latest BIS Annual Report:

“The crisis revealed once more that this view [substitutability between market and institutional financing] does not emphasize sufficiently the strong interdependencies between on-balance sheet and market-based intermediation. Institutions depend on markets for revenue generation, risk management and funding, while market functioning depends on institutions to provide market-making services, securities underwriting and lines of credit. These interdependencies between markets and institutions were showcased by the difficulties that institutions faced in funding their operations in illiquid markets and the problems created in the functioning of markets when the participating institutions were under stress. Heightened concern about counterparty risk led to a seizing-up of markets and undermined the liquidity of portfolios and firms’ funding strategies, causing large losses. An important message from the crisis is that the stability of both channels of financial intermediation is supported by a common capital base.” Large financial firms play an important role in both the on-balance sheet and market-based intermediation channels.<sup>17</sup> Such interaction between large financial institutions and markets gives rise to some externalities, including those resulting from liquidity shocks.

Ensuring financial stability means addressing externalities—costs that, through its actions, an institution imposes on others but does not bear itself. Two externalities are central to systemic risk: the first is joint failures of institutions resulting from their common exposures at a single point in time—common exposures because of shocks that come from outside the financial system or because of linkages among intermediaries. The shocks may take a variety of forms, including both credit and _liquidity shocks_ and their interaction, while the linkages arise from the complex web of daily transactions. The second externality is what has come to be known as pro-cyclicality, the fact that, over time, the dynamics of the financial system and of the real economy reinforce each other, increasing the amplitude of booms and busts and undermining stability in both the financial sector and the real economy. Properly designed, each component of the framework—focusing on instruments, markets and institutions—can mitigate these sources of instability”.<sup>18</sup>

> 14 CEBS, ‘Second part of CEBS’S Technical Advice to the European Commission on Liquidity Risk Management”, June 17, 2008, pages 23-24.

> 15 OSFI Canada, ‘Guideline” (B-6) on the Subject of Liquidity’, December, 1995.

> 16 The complexity of the bank will have a bearing on the design of the liquidity management system and tools used by each bank. There also implications for the management of collateral (encumbered or unencumbered) and across jurisdictions, which could prevent the quick sale or cross-border transfer of assets. <mark>More later.</mark>

> 17 BIS, Annual Report 2009, page 51.

> 18 BIS Annual Report 2009, page 125.