1 Firms became over-confident in their ability to hedge or exit positions if conditions changed, failing to recognise that many participants would be attempting to do the same and that market liquidity would then evaporate. Indeed, given a change in sentiment, the increased integration of financial markets transmits risks just as much as it disperses them. 1  2  See Bank of England Financial Stability Reports July 2006 and April 2007. BIS Review 50/2008  Banks’ funding thus became increasingly vulnerable to a sudden shift in financial market conditions. As covered extensively elsewhere, 2 the crystallisation of this risk in August 2007 led to a sharp decline in liquidity across a wide range of markets (as shown in Chart 3). Funding pressures intensified as asset managers lowered demand for asset-backed securities and complex products more broadly, to lower risks and to guard against pressures from their investors for early redemption. And as banks attempted to fund contingent claims, liquidity in wholesale term markets dried up – adding to the strain. A number of institutions across the globe, such as Northern Rock, IKB and Bear Stearns have succumbed to the pressure, necessitating public sector intervention to support financial stability. Section III: Defences against liquidity risks Banks have a range of defences to a sudden decline in the availability of wholesale funds. Recent developments have highlighted a number of limitations in these defences in addressing the recent system-wide liquidity shock. One potential counter-measure to liquidity pressures is to transform illiquid assets into cash.
A bank holding a buffer of reliable high quality liquid assets, such as Treasury bills or other government securities, can draw on them immediately and directly in the event of a sudden withdrawal of market liquidity or an unexpected increase in its funding requirement. Of course, safe, liquid assets offer lower returns than other types of assets, so there is an opportunity cost in maintaining such a liquidity cushion on the balance sheet. But such assets nevertheless provide the most readily available and reliable provision against a crystallisation of liquidity risk. Unfortunately, banks’ reserves of reliable liquid assets have proved insufficient to meet the recent funding shock. With hindsight, incentives to raise the efficiency of maturity transformation have lowered this safety valve in the system too far. I would like to examine in a little more detail the UK experience in this respect. In the midnineteenth century, UK banks held on average sixty percent of liquid assets as a proportion of total deposits, an extremely high ratio explained by the frequency of liquidity crises around that time. Shortly after the 1866 Overend and Gurney crisis, the Bank of England accepted a role as lender of last resort, leading banks to relax their extremely conservative (and inefficient) approach to liquidity. The average liquidity ratio dropped to around thirty percent of total deposits.