For instance, scenarios should take account of the extent to which many firms might respond to a common shock in a similar way, with potential implications for market prices or market liquidity. The likely amplification of price moves as financial institutions attempt to exit “crowded” trades and liquidity dries up is an important example. Indeed, given the importance of market liquidity for the efficient execution of banks’ dynamic hedging strategies and for their activities in the wholesale funding and credit risk transfer (CRT) and securitisation markets, it is essential that stress tests factor in extreme, yet plausible, scenarios for liquidity conditions in these markets, recognising that market liquidity can evaporate very quickly, particularly for complex structured financial instruments. And it is also essential to factor in increased liquidity needs linked to contingent calls, associated, for instance, with funding margin payments. Capital and liquidity buffers A sizeable buffer of capital and liquidity can help a bank to withstand a shock that threatens its solvency or would otherwise leave it with insufficient liquidity to meet its obligations as they fall due. But a bank’s private choice as to the size of its capital or liquidity buffer may not be aligned with the socially optimal choice, as firms will not naturally take account of (or “internalise”) the implications of their distress or failure on the financial system more broadly – for example through the possibility of contagion to other firms and impairment of the financial intermediation system. That provides the justification for prudential regulation.
With a strong foundation in place, supervisors can then select the alternatives within Basel II that are most appropriate for their own circumstances. In addition to the steps I have outlined for supervisors, there is also a wider set of preconditions that we as central bankers can help to promote, including appropriate macroeconomic policies which are consistent and sustainable over time. All these considerations allow us to underline the notion that the achievement of financial stability must be based on a broad range of tools which we should all seek to strengthen. I don’t want to play down the challenge of achieving a coherent approach to financial stability that fosters financial innovation, promotes a level playing field and ensures that the banking system can remain resilient in the face of internal and external shocks. Nevertheless, I believe that the effective implementation of Basel II will contribute to the proper functioning of the economy under a wide range of circumstances. Conclusion To conclude, I think that Basel II recognises the importance of a combination of micro and macro factors for achieving greater financial stability. Furthermore, I would say that Basel II incorporates some of the key basic principles that are also built in modern approaches to monetary policy: a flexible and forward-looking approach, anticipatory rather than reactive behaviour to risk, and the need to take into account market views.