ben s bernanke : liquidity provision by the federal reserve speech by mr ben s bernanke, chairman of the board of governors of the us federal reserve system, at the federal reserve bank of atlanta financial markets conference, sea island, georgia ( via satellite ), 13 may 2008. * * * well - functioning financial markets are an essential link in the transmission of monetary policy to the economy and a critical foundation for economic growth and stability. however, since august, severe financial strains have shaken this foundation. a sharp housing contraction has generated substantial losses on many mortgage - related assets and a broad - based tightening in credit availability. consistent with its role as the nation's central bank, the federal reserve has responded not only with an easing of monetary policy but also with a number of steps aimed at reducing funding pressures for depository institutions and primary securities dealers and at improving overall market liquidity and market functioning. 1 in my remarks today, i will begin by reviewing the principles that should guide central banks'actions to support market liquidity. then, in light of those principles, i will discuss the liquidity measures implemented by the federal reserve in response to the financial turmoil. i will conclude by offering some thoughts on liquidity regulation. the principles behind central bank liquidity provisions the notion that a central bank should provide liquidity to the banking system in a crisis has a long intellectual lineage. walter bagehot's lombard street, published in 1873, remains one of the classic treatments of the role of the central bank in the management of financial crises. bagehot noted that the basis of a successful credit system is confidence. in one passage, he writes, " credit means that a certain confidence is given, and a certain trust reposed. is that trust justified? and is that confidence wise? these are the cardinal questions " ( p. 11 ). he pointed out that confidence is particularly important in banking and in other situations in which the lender's own liabilities are viewed as very liquid by its creditors. in such situations, as bagehot put it, " … where the'liabilities ', or promises to pay, are so large, and the time at which to pay them, if exacted, is so short, " borrowers must demonstrate " an instant capacity to meet engagements " ( p. 11 ). meeting creditors'demands for payment requires holding liquidity – cash, essentially, or close equivalents. but neither individual institutions, nor the private

##ised banks. let me emphasise again that i don ’ t advocate replacing the current basel ii regime with a leverage ratio. this would be unwise, as we would forgo all the advantages of the riskweighted requirements. in particular, we would lose valuable indicators of banks ’ levels of risk. and, quite frankly, there is no real alternative in sight, at least not readily. in discussions with my central banking and regulatory colleagues i detect increasing interest and willingness to examine and consider the proposal of a leverage ratio as a complement to the risk - weighted capital regime under basel ii. governor nout wellink, the chairman of the basel committee on banking supervision, has recently said that the committee is currently considering measures to strengthen basel ii by supplementing it “ with simple, transparent gross measures of risk ”. 22 last month, the german council of economic experts advised the german government and parliament to introduce a leverage ratio as a robust supplement to basel ii. 23 other countries may also find it worthwhile to consider introducing a leverage ratio, even if any formal international agreement should fail to materialise. in doing so they would not only enhance financial stability in their own banking systems, but would also contribute to a more stable international financial system. finally, it is encouraging to note that a number of banks have made voluntary commitments not to exceed certain predefined leverage limits. adding a leverage ratio to basel ii will reinforce banks ’ capital and strengthen capital regulation. however, we must remain realistic. introducing a leverage ratio doesn ’ t solve everything. a leverage ratio addresses excessive leverage in the banking system. it does not nout wellink, “ the importance of banking supervision in financial stability ”, speech given on 17 november 2008. german council of economic experts, “ mastering the financial crisis – strengthening the forces for growth ”, 12 november 2008. address credit concentration, excessive maturity mismatch or undue reliance on asset market liquidity. financial crises, let alone financial cycles will never be eliminated. our aim must be to ensure that the negative consequences, both to banks and to the real economy, remain manageable. putting in place a shock - absorbing leverage ratio to complement the risk - weighted framework of basel ii will help us get one step closer to this goal.