Third, liquidity requirements can be increased to reduce the risk that the firm will have to engage in a fire sale of assets that might deplete its capital. Also, a liquidity buffer gives the firm’s management time to respond to bad events without having to resort immediately to selling assets. Fourth, a lender-of-last-resort can provide a liquidity backstop that makes funding liquidity more resilient. Consider the case when a counterparty is uncertain about how other potential lenders view a firm’s solvency. If there is no lender-oflast-resort backstop, this may cause firms to be unwilling to lend, not because they perceive the counterparty as insolvent, but, instead, because they are worried about what others think. That is, I may be unwilling to lend to you, not because I perceive you as insolvent, but because I am uncertain about how others view your solvency. If I do lend and others don’t share my view, will I be able to get my money back? With a lender-of-last-resort added to the picture, I no longer need to know what others think. As long as the lender-of-last-resort is available, if I am correct in my assessment that the firm is solvent, then I can be assured that I will be paid back. This issue was particularly relevant during the financial crisis when counterparties even pulled back from firms that were widely viewed as solvent. The Federal Reserve stepped in and created funding backstops for a wide array of assets, such as commercial paper and asset-backed securities.
Where a country has transparently been pursuing an unsustainable macro-economic policy, most people find it easy to accept that that country should bear the burden and adjust, painful though that may be. Many people find this harder to accept where, as in the present case, conventional macro-economic policies had, for the most part, been relatively responsible. There were certainly adjustments to macro-economic policy that needed to be made - a more flexible exchange rate regime in some cases, for example, or a somewhat tighter overall macro-economic stance, with perhaps some adjustment between fiscal and monetary policy. And, once the capital outflow had started, macro-economic adjustment had to be harsher than might otherwise have been necessary, in order to re-establish confidence. But there are real dangers in extreme market movements or in excessively severe macro-economic adjustment to contain them. The political and social consequences are all too apparent in parts of Asia; but even without that there is a danger of a vicious circle of domestic default and systemic financial weakness in the affected country. And that could have seriously adverse implications - in terms of both financial and economic knock-on-effects - for the global economy. That, essentially, is why it may be in the self-interest of the international community to attempt to mitigate the market and macro-economic adjustment pressures by providing financial support.