There were signs of strain in particular segments of these markets, such as dislocations in forward exchange rates and a notable decline in the liquidity of currency swaps. However, market participants were generally able to execute trades and manage currency exposures in these markets on an uninterrupted basis. The resilience of foreign exchange markets owed in part to the availability of CLS Bank for  2  BIS Review 40/2010  eliminating time gaps in the settlement of different currencies, to the efficient collateral exchange achieved through credit support annexes and to the standardization of trade documentation. Credit intermediation and market disruption While those capital markets demonstrated meaningful resilience to financial stress, that was not the case for other parts of the financial system – namely, those involved in more complicated forms of credit intermediation. Many of the most acute problems were driven by a build-up in leverage in which large amounts of opaque, illiquid, long-term assets were financed by short-term liabilities. These activities took place both in traditional financial intermediaries and in what is often referred to as the shadow banking system. The shadow banking system performs a function similar to that carried out by banks and other financial institutions. In particular, it takes the short-term, highly liquid investments that households and other investors want to hold, and it uses them to fund the longer-term, relatively illiquid loans that businesses and households demand to finance their economic activity.

The bottom line is that the entire system was suffering from a self-reinforcing cycle of liquidity runs and concerns about the solvency of financial institutions. An effective policy response had to address both aspects of this cycle. Responding to the demand for dollar liquidity It took government actions on many fronts to stabilize the financial system. Many of these efforts were aimed at addressing the solvency problems facing the financial sector, including the injection of capital into financial institutions and two of the housing GSEs. These efforts were critically important to the recovery of financial markets. However, l will focus my remarks on another important part of the government response – the actions taken by central banks and other government entities to address the liquidity strains in the markets. Central banks around the world responded vigorously to the erosion of liquidity conditions. The lender-of-last-resort function of central banks proved to be critical for supporting market functioning and stemming contagion. For the Federal Reserve, this function had to evolve in response to the nature and location of the liquidity disruptions it sought to address. The Fed’s traditional lender-of-last-resort tools are designed to ensure adequate liquidity for depository institutions. But the liquidity strains went beyond the banking sector and into the market-based credit system. The traditional tools were not adequate to address the problems faced in this more complicated intermediation system, and hence the Fed had to innovate – under extreme market conditions and with little time to spare.