Frankly, it has been shocking over the past year or so to discover how many medium-sized banks and building societies did not hold government bonds or other very high quality assets; or, if they did, how many did not have a regular presence in the gilt repo market or even had no capacity to repo at all. Turning up in the core secured-funding markets for the first time for years is an absolute give away of distress. All that has to change. Market-maker of Last Resort What I have said so far could be mistaken to imply that only banking markets matter. That would be misleading. The capital markets obviously matter too. Indeed, the current crisis has illustrated just what a mess can result from liquidity draining out of those markets. Market liquidity is endogenous: participants thinking that it might dry up can contribute to its doing so. In the early phases of this crisis, by virtue of holding large “trading” books that were marked to market, banks and other traders found themselves having to make very large portfolio write downs in the face of sharp rises in liquidity premia in asset markets. As highly-levered institutions, those mark-downs depleted their net worth to the point of imperilling solvency. That caused a retrenchment in the availability of credit, helping to plunge the world economy into recession, and so impairing the value of more traditional loan books, in a vicious spiral. So it would have been better if, somehow, we could have preserved the liquidity of the markets.
21 Banks earn a return from providing liquidity services, and so make a trade-off in deciding how much liquidity risk to run. But, because of the spillover effects from bank failures, the overall social cost of banks’ liquidity risks crystallising can be considerably greater than the costs for the individual banks themselves. Regulation by the micro-prudential authorities has been the primary tool for dealing with that issue. There is currently a very important, and long overdue, international debate about how to improve the regulation of liquidity. I want to dwell today on just one important element of this debate. This concerns whether or not the assets counted by prudential regulators as part of a bank’s liquidity buffer should be defined to include all of the assets held by the bank that are eligible in the operations/facilities of the central banks to which the bank has access. Some argue that they should. The Bank of England would regard that as a big mistake. For the reasons I have described, the collateral eligible at most central banks goes way beyond securities that can be relied upon in stressed conditions to be liquid in private markets (whether outright or repo). So if they all counted as core-liquidity for regulatory purposes, banks would in effect be liberated from having to hold a buffer of low-yielding assets that they could confidently use in the market before they turned to us.