It should vary according to the type of collateral which banks provide, as indeed it does to some extent now. Access to central bank money or asset swaps should, as far as possible, encourage banks to manage liquidity risk prudently. Without the correct pricing structure, the incentives to encourage future risk taking are obvious and potentially large. Valuation margins – or haircuts – are used to protect our balance sheet. By themselves, they aren’t sufficient to create a general pricing structure. The cost imposed by a margin depends primarily on the difference between the costs of secured and unsecured funding, and that will vary across banks and over time. So the key is in the interest rates charged by the central bank. The second challenge is to overcome the ‘stigma’ problem that has plagued the use of central bank facilities throughout the crisis. Commercial banks have feared that, by accessing funding from the central bank, they would acquire a ‘black spot’ in the market. They have been reluctant to come to their central bank unless in good and extensive company. These are challenges that all major central banks are grappling with. They will not be easy to overcome. But with our international colleagues we are aiming to devise a framework that does so.
It was concerns about confidence in the banking system as a whole that explain why the major central banks acted together in December, which in our case meant extending the range of collateral accepted in our regular auctions of 3-month lending. Auctions like this can play a useful role but, as we saw with Bear Stearns, a more continuously available facility may sometimes be needed to avoid an immediate loss of confidence. That is why, in April, when confidence was particularly fragile, we introduced a backstop that is available every day – the Special Liquidity Scheme. As I said in September, in providing such a backstop, we face a balancing act, between avoiding a major shock to the system and encouraging future reliance on the same cheap but risky funding sources. The Special Liquidity Scheme aims to do this by exchanging liquid for illiquid assets that existed only before the end of last year. We intend to learn from the experience of the Scheme to put in place a liquidity facility that works in all seasons – both ‘normal’ and ‘stressed’. It will be part of a set of reforms to our Red Book, to be announced later this year. Any such facility will need to meet two challenges: it will need the right pricing structure and it will need to overcome the ‘stigma’ problem that has affected access to all central banks during the current crisis. BIS Review 75/2008  3  The pricing structure will be key to striking the right balance.