vitor constancio : deutsche bank prize attribution to raghuram rajan speech by mr vitor constancio, vice - president of the european central bank, at the panel on “ liquidity and monetary policy ” at the occasion of deutsche bank prize attribution to raghuram rajan, frankfurt am main, 26 september 2013. * * * it is a great pleasure for me to participate in this panel on the occasion of the award of the prestigious deutsche bank prize – and, in particular, to be associated with this event honouring the work of raghuram rajan. i became a greater admirer of raghuram ’ s work, even if not a wholly uncritical one, after his premonitory paper1 presented at the jackson hole central banking conference in 2005. it was a paper i distributed widely to friends and colleagues at the time. but, of course, raghuram ’ s previous work was also quite well known – particularly his research on the theory of banking, on bank capital or liquidity risk, and on liquidity creation by banks with the unavoidable financial fragility that this implies2. that research, conducted often with douglas diamond, fits well with our panel theme today. liquidity has been a somewhat elusive concept ever since keynes defined it in his treatise on money in 1930 and hicks developed it in subsequent work3. liquidity is a relative concept, a matter of degree, and we all start from keynes ’ s definition that one asset has more liquidity than another if it is “ more certainly realizable at short notice without loss, ” here, “ realizable ” means the capacity to be exchanged into narrow money or, even better, into goods and services. where does the demand for liquidity come from? the need for liquidity does not arise in the perfect and utopian world of general equilibrium with arrow ’ s debt contracts or complete calculable contingent claims. also, as hicks pointed out, liquidity demand does not appear in traditional portfolio analysis, which he tried to expand by adding a liquidity preference complement. but there are many ways of changing the assumptions of perfect general equilibrium analysis to generate demand for liquidity. for instance, rajan and diamond ( 2001 ) assume that assets are illiquid and so they “ cannot be sold or borrowed against for the full value they generate ” 4 which implies that there is a demand for liquidity. jean tirole and ben

08 26 / 11 / 08 21 / 11 / 08 16 / 11 / 08 11 / 11 / 08 06 / 11 / 08 01 / 11 / 08 27 / 10 / 08 22 / 10 / 08 17 / 10 / 08 12 / 10 / 08 07 / 10 / 08 02 / 10 / 08 27 / 09 / 08 22 / 09 / 08 17 / 09 / 08 12 / 09 / 08 chart 3 nominal exchange index sept. 12 / 08 = 100 brazil chart 4 colombian government local bond zero - coupon rates july 2008 - december 2008 10 years 15 % 14 % 13 % 12 % 11 % 10 % 9 % 8 % chart 5 10 year government bond zero coupon rates latin america * 21 % 19 % 17 % 15 % 13 % 11 % 9 % brazil mexico colombia 28 - dic - 08 13 - dic - 08 28 - nov - 08 13 - nov - 08 29 - oct - 08 14 - oct - 08 29 - sep - 08 14 - sep - 08 30 - ago - 08 15 - ago - 08 31 - jul - 08 16 - jul - 08 01 - jul - 08 7 % peru * 7. 25 years for brazil f t bl b sen however, the shock had more widespread consequences. as key markets in the u. s. were closed ( e. g. the short term commercial paper and the abs markets ), short term external funding for emerging markets was severely hampered. those countries in which the financial system depended significantly on foreign financing suffered stress in both the foreign exchange and the local short term lending markets as banks and other institutions scrambled to close their foreign currency liquidity gaps. however, this was not the case for colombia, where regulation prevented local banks from being exposed to maturity mismatches between currency and foreign currency. it also restricted their non - derivative net foreign asset position to be positive which effectively inhibited the existence of a foreign currency interbank loan market. in other countries, pressures on the foreign exchange market and financial stability emerged from two things : the exposure of the corporate sector to currency risk and the realization of huge losses after the depreciation of the local currencies against the us dollar. again, this was not the case of colombia where capital controls and exchange rate volatility limited the corporate sector ’ s external indebtedness. at the same time, regulation limited the gross foreign exchange derivative position of banks to five times their net worth or less. this was established to curb bank counterparty risk in