The inadequacies of banks’ liquidity management became apparent when some markets for long-term debt securities (including ABS, ABS CDOs, etc.) experienced a sudden re-pricing, resulting from the fact that risks were not properly reflected in their prices. Banks faced  BIS central bankers’ speeches  1  substantial liquidity outflows and shortages owing to their excessive exposure to these instruments and their excessive reliance on short-term and volatile secured market funding sources. In the US, this phenomenon mainly materialised as a “run on repo”;1 in the euro area, it resulted into drying up of foreign currency funding, severe strains in bank unsecured funding, and/or a reduced access to repo through clearing houses. In all cases, the central bank had to step in and to expand its liquidity provision to banks. What does this imply for liquidity regulation? Regulations should start from first principles, and we therefore have to identify the market failures or negative externalities that liquidity regulation aims at addressing. I consider that there are three main objectives for liquidity regulation: a) to reduce the impact of uncertainty on the bank risk profile, b) to build up liquidity buffers and c) to mitigate the systemic characteristics of a liquidity crisis. Maturity transformation gives rise to liquidity risk since, by definition, a bank engaging in maturity transformation cannot honour sudden and large withdrawal requests by depositors. They may face similar difficulties if interbank market lenders refuse to roll over their loans.
The new set of liquidity requirements will provide for a better monitoring of risks on banks’ balance sheets and will limit the social cost of liquidity crises. It has to be combined with actions ensuring a proper functioning of the money market, such as reform and oversight of reference rates. It should be seen as a complement to regulatory reforms that improve market discipline in other segments of the banks’ liability structure, such as capital buffers and the new bail-in rules for senior bond-holders and uninsured depositors. A more far-reaching question, which I did not address in this speech, is whether the increased risk-sensitivity of bank liabilities under the new regulatory regime will constrain the role of banks as providers of liquidity services to the economy, or as creators of “quasimoney”. If so, this could put undue pressure on central banks as producers of the only truly safe and liquid asset – bank reserves. This makes it even more important for governments to be fiscally responsible so that Treasuries can keep or regain their role as safe and liquid instruments. Going forward, central banks will continue to act as lenders of last resort, but the crisis has helped us better understand the conditions for it to be socially useful. One of these is an effective liquidity regulation that constrains the business models of banks in a way that ensures that liquidity risk is self-insured. If properly priced, instruments such as a Committed Liquidity Facility can complement liquidity regulation while protecting monetary policy.