But it isn’t that simple, and tonight I want to outline the role of financial markets and non-bank institutions (which sometimes go under the somewhat pejorative term of shadow banks) 1 within the overall financial system and describe how, with sufficient resilience, they play a number of key roles in the financial system, including offering borrowers alternatives to bank lending. Nevertheless, I also want to explain why there is significant and increasing emphasis on the risks they can pose to financial stability. Put simply, it is quite often said that we are living in unprecedented times in the performance of financial markets. The simple narrative around banks is that they over-extended themselves (over-leveraged in terms of the ratio of assets to capital and over-extended in terms of the ratio of illiquid to liquid assets) in the run-up to the crisis, and the resulting problems had two closely linked and malign effects: first, the crisis jeopardised the provision of those core financial services which banks provide and on which all of us depend; and second, by so doing – and being too big or complicated to deal with as failed companies – they required the use of taxpayers’ money to bail them out. That’s the story, and it explains why the public policy actions taken both immediately after the crisis (bail-outs) and the subsequent post-crisis reforms have been directed at protecting those or core financial services and seeking to ensure that taxpayers’ money does not need to be put at risk.
To be clear however, QE asset purchase operations were not designed to tackle a liquidity problem in the financial system. Rather, the impact on liquidity was one of the channels through which QE has affected the real economy and thus has had its intended effect in monetary policy terms. While estimates of the impact of QE are inherently uncertain, one of the desired outcomes of central bank asset purchases is to lower yields thus affecting longer term interest rates and creating a positive economic effect. In doing so, QE can improve the functioning of financial markets by reducing liquidity premia. The third post-crisis development is the impact of the growth of automated trading in financial markets, and the challenges this poses for maintaining continuous market and liquidity. Over the last year volatility in many financial markets has picked up from a low base and we have seen some acute but short-lived incidents of extreme volatility and impaired liquidity in secondary markets. On 15 October last year there was unprecedented volatility in the US Treasury market, and on 15 January this year there was substantial volatility in the Swiss Franc exchange rate following the unexpected decision by the Swiss National Bank to remove its Europe/Swiss Franc floor. Now, central banks are known for their powers of understatement, so what do I mean by words like “unprecedented” and “substantial”. On 15 October, 10 year US Treasury yields moved intra-day by around 8 standard deviations of preceding daily changes.