But a system-wide shock with a broader impact on market liquidity conditions could quickly change the situation. Liquidity at fund level may be squeezed if many investors wish to liquidate their unit shares at the same time. The resulting first-mover advantages and selling pressure could amplify stress in financial markets, especially if conditions are already fragile. One reason why the Federal Reserve Bank of New York decided to facilitate the private-sector bail-out of LTCM was precisely because it was concerned about market dislocations should the company fail on some of its obligations. Letting LTCM go into disorderly fire-sale liquidation was seen as risking a severe drying-up of market liquidity, which could have damaged financial markets and the wider U.S. economy.4 Considering the current global and domestic uncertainties affecting financial market developments, I am seriously concerned about declining market liquidity and the role that investment funds might play in a possible stress scenario. Liquidity mismatches and leverage are structural in nature and often build up slowly over time. In the euro area, we observe that investment funds have been taking on higher credit and duration risk in the current market environment. And we have strong indications that liquidity risks are building up in the fund sector. The share of less-liquid assets in that sector has been growing constantly since the global crisis, while liquidity and cash buffers have been declining.
In emerging Asia, two key areas where there is the need and opportunity for further progress are in the financial system and in the monetary policy framework. The financial sector plays an important role in the flexibility and adaptability of economies to change, in the resilience of economies and in the capacity of the monetary authorities to respond to adverse shocks to asset prices or demand. Although much has been achieved in Asia over the past decade, as the damage inflicted by the crises has been repaired, further reform will be important to the capacity of these economies to innovate and grow and to live more comfortably with openness to capital flows. This requires stronger banks and more developed capital markets. Thus far, we have seen more progress on the former than the latter, but both are important and there remains considerable scope for broadening and deepening capital markets in emerging Asia. The extent of financial innovation in the industrial economies makes it possible for Asian countries to take advantage of huge  BIS Review 65/2007  3  improvements in the efficiency of financial intermediation. Embrace of these reforms will help ensure that high levels of domestic savings are deployed more efficiently, that companies and financial institutions are able to manage risks more effectively and that the financial system is more resilient in the face of future stress. Monetary policy regimes in much of Asia are burdened by two different types of constraints on independence.