The focus here is on maturity transformation and affordability risk in mortgage lending. In the short term, this may allow banks to increase their profitability, but the flip side is that this also makes them more vulnerable to interest rate shocks and corrections on the mortgage and residential real estate markets. Domestically focused banks would be particularly exposed to a major interest rate shock. As we explain in our Financial Stability Report, in the event of a normalisation of interest rates, banks would initially benefit from the restoration of the liability margin. However, a major interest rate shock would cause net interest income to fall significantly at many banks, potentially resulting in losses. The greater a bank’s maturity transformation is, the higher these losses will be. Even if the current low interest rate period were to continue and interest rates were only to rise very gradually, the possibility of a major interest rate shock should not be ruled out. Experience has shown that interest rate corrections can sometimes be sudden and sharp. It should also be borne in mind that interest rates on the money and capital markets are currently more than 300 basis points lower than at the beginning of 2008. In other words,  2  BIS central bankers’ speeches  even if interest rates were to return to levels previously considered normal, this would still constitute a major correction.
Market making means the temporary transfer of risk to intermediaries to smooth out imbalances of supply and demand. But market makers have to be able to bear the risks. Pre-crisis, market makers funded their inventory with short-term borrowing and very small amounts of loss absorbing capital. As a result, when exposed to a severe stress, market makers simply disappeared from the scene. So liquidity is a good thing. It does play a key role in the functioning of effective markets. And financial market intermediation and engineering can help ensure the price is as low as possible, consistent ultimately with an asset’s underlying characteristics. But taken too far, these can create the illusion of liquidity rather than liquidity itself and expose the system to risk when the illusion disappears. We should not in particular refer to metrics of the pre-crisis period to see what some “good” level of liquidity looks like. Some markets may indeed not function as smoothly or cheaply as they did in the run up to this crisis. But that may well be the counterpart of less poorly priced liquidity risk in the system. Promoting true liquidity That is not to say that nothing can be done in this area. First, we should ensure that regulatory changes are coherent. Regulators have dealt with the under-pricing of liquidity risk in part by remedying inadequate capital requirements.