The rational actions taken by even the strongest financial institutions to reduce exposure to future losses have caused significant collateral damage to market functioning. This, in turn, has intensified the liquidity problems for a wide range of bank and nonbank financial institutions. In this environment, banks have faced several different types of liquidity and funding challenges. They have been called on to fund a range of different contingent liquidity and credit commitments, as is typically the case in crises. The substantial impairment of securitization and syndication markets has been an additional challenge because it has reduced banks’ access to liquidity and their capacity to move assets off balance sheets. As the market value of many securities has declined, and investors have reduced their willingness to finance more risky assets, liquidity conditions have eroded further. In response, even the strongest institutions have become much more cautious, building up large cushions of liquidity, bringing down leverage and reducing financing for their leveraged counterparties. Policy measures The self-reinforcing dynamic within financial markets has intensified the downside risks to growth for an economy that is already confronting a very substantial adjustment in housing and the possibility of a significant rise in household savings. The intensity of the crisis is in part a function of the size of the preceding financial boom, but also of the speed of the deterioration in confidence about the prospects for growth and in some of the basic features of our financial markets.

These limitations were particularly damaging in a period in which significant innovation in financial instruments and market structure was coupled with relatively stable macroeconomic and financial conditions. Uncertainty about the future, and the greater complexity of leveraged structured products, created a dense fog around estimates of potential loss, making institutions and markets more vulnerable to an adverse surprise when conditions changed, and making it harder to manage the many principal agent problems inherent in the financial business. 2  BIS Review 27/2008  In effect, some major banks and investments banks made the choice to follow the market down as underwriting practices eroded. They took on more exposure to low probability but extremely adverse events, despite the potential consequences of getting caught when the music stopped. And even though the largest firms were able to move quickly to protect themselves as conditions worsened, those actions had significant negative effects on market functioning and liquidity. The current episode has a basic dynamic in common with all past crises. As market participants have moved to reduce exposure to further losses, to step on the brake, the brake became the accelerator, amplifying the shock. Measured risk has increased more quickly than many institutions have been able reduce it, and attempts to reduce it have added to volatility and downward pressure on prices, further increasing measured exposure to risk. Uncertainty about the market value of securities and about counterparty credit risk has increased, and many hedges have not performed as intended.