9 The balance sheet cost associated with the interbank trade can be thought of as capturing the additional risk introduced into the system by that trade. One side effect of interbank trades is that they create a network of exposures that can contribute to financial fragility, as we saw during the crisis. Central bank liquidity provision Let me now turn to the question of broad-based liquidity provision by central banks. As Ulrich notes, there is an academic literature on the topic that focuses primarily on the incentives that individual financial institutions may have to take on excessive risk if they expect the central bank to provide insurance ex post; an incentive often referred to as moral hazard. This framing had become so pervasive that central bankers relied on constructive ambiguity – the idea that if market participants were unsure about whether the central bank might supply liquidity, they might not be as tempted to take privately beneficial but socially costly actions. I don’t intend to discuss constructive ambiguity, but I find it striking that there is little research on this topic directly related to central banking that could help us think of the costs and benefits of such an approach. 10 More generally, now might be a good time for academics and central bank researchers to take a fresh look at the issues of central bank liquidity provision, taking into account, in particular, stigma and liquidity regulation. 11 Let me start with stigma.
Third: Market functioning I have to mention first the assessment of the role of credit rating agencies, their small number, the transparency of their rating methodology, possible conflicts of interest in particular as regards structured finance instruments. Excessive exclusive reliance on credit ratings by investors without carrying out due diligence or conducting further own risk assessment is a problem as well. The road map also includes a reflection on the consequences of the originate and distribute model of banks for credit markets. Does it induce wrong incentives? A last item in this list relates to non-regulated debt markets and mortgage markets, which might deserve a hard look in the light of recent experience. Finally: The regulatory framework Above all, liquidity risk management relating to complex structured products needs to be investigated. We need a wider concept of concentration risk including wholesale and interbank markets as well as intragroup exposures. We have to look at warehousing and pipeline risk, deal with possible regulatory incentives to move risk off balance sheet into SPVs. We have to assess the links between the regulated and the non-regulated part of the system, including the optimal perimeter of supervision. Special purpose investment vehicles and conduits were used as off-balance sheet investment vehicles. These were prone to liquidity mismatches between their assets and liabilities, causing contingent credit and liquidity lines to be drawn on banks, and resulting in an increased demand for money market liquidity.