I would like to highlight four emerging lessons from the current crisis that should help prevent future problems. First, we need to understand better the various sources of liquidity risk, particularly under stressed conditions. Second, banks need to develop more effective contingency funding plans. Third, banks should support improved market functioning and stricter market discipline through better disclosure. And finally, supervision should ensure that banks’ liquidity risk management is undertaken to a more robust standard, in order to internalise some of the costs of a bank failure on the wider financial system. I shall cover these briefly in turn. Banks and public authorities alike need to develop a more in-depth and more complete understanding of the various forms in which liquidity risk can arise. That requires both a careful analysis of the various potential sources of liquidity risk, and of how such risks may crystallise under stressed market conditions. As outlined earlier, in today’s financial environment, it is not just the simple maturity transformation between deposits and loans that generates liquidity risk for banks. To this must be added contingent risks, such as the potential activation of liquidity lines to off-balance sheet vehicles, or the drawing of committed facilities extended to corporate customers. Contingent risks may also arise, in a variety of forms, from complex trading instruments, as detailed well by the Institute for International Finance (IIF) last year.
4  BIS Review 50/2008  Section IV: Lessons The recent turmoil has highlighted clear deficiencies in banks’ liquidity risk management. And it has also demonstrated that these deficiencies pose serious risks to financial stability and thus to the economy more broadly. To address this risk in the near term, central banks globally have provided additional liquidity to the banking system and emergency operations have been conducted to support Northern Rock and Bear Stearns. Additional liquidity has been provided at longer-term maturities to address the problem of funding an unexpected overhang of illiquid assets. The Bank’s recently launched Special Liquidity Scheme is enabling UK banks to liquefy a proportion of their outstanding stock of illiquid assets by swapping them for high quality liquid government securities, while ensuring that credit risks remain very clearly with the banks. That should ease current funding pressures. But in the medium term, it is clear that action is needed to strengthen the financial system’s defences to liquidity risk to limit the likelihood of any recurrence of the recent problems. Central banks globally are reviewing the lessons of the episode for their market operations, for example, to ensure that the usefulness of facilities is not undermined by perceptions of stigma that may be attached to a bank that uses them. But it is clear that primary responsibility for bolstering the defences lies with the banks themselves and that supervisory regimes for liquidity risk need reinforcing to support that process.