Dealers de-risked their balance sheets rapidly as the crisis hit, and this reminds us that their capacity and willingness to stand in the way of major market moves (akin to catching a falling knife) was always constrained. 6 And all of this happened before any new regulations were put in place. Last on this point, it is worth recalling the background to the large increase in inventories from around 2002/04. Here, regulation does appear to have played a role, and not a good one. The first amendment to the Basel I capital standard came in the mid 1990s in the form of the so-called Market Risk Amendment. It enabled a substantial reduction in the capital held against trading book assets such as inventories, to a level that could be less than 1% of those assets. To illustrate this point, here is a quote from the FSA’s report into the failure of RBS. “The capital regime was more deficient, moreover, in respect of the trading books of the banks ….. the acquisition of ABN AMRO meant that RBS’s trading book assets almost doubled between end 2006 and end 2007. The low risk weights assigned to trading assets suggested that only £ billion of core tier 1 capital was held to cover potential trading losses which might result from assets carried at around £ billion on the firm’s balance sheet. In fact, in 2008 losses of £ billion arose in the credit trading area along (a subset of total trading book assets).
A regime which inadequately evaluated trading book risks was, therefore, fundamental to RBS’s failure.” (FSA (2011)). I do not doubt that the reversal of this capital treatment of trading books has had an impact on dealer inventory levels by increasing the capital intensity. But I don’t accept that the fairly ephemeral position that emerged shortly before the crisis was fit for purpose or sustainable. What are we therefore doing about the fragility of market liquidity and the risks to both financial stability and the state of the real economy that arise from it? First, we are working hard to understand better these risks and how they could manifest themselves. As the Bank of England’s Financial Policy Committee stated at the end of March, our concern is that investment allocations and the pricing of some securities “may presume that asset sales can be performed in an environment of continuous market liquidity.” (FPC (2015)). We are: gathering better data and thus building a greater understanding of the channels through which market liquidity can affect financial stability and economic activity; establishing a better understanding of how asset managers form their strategies for managing liquidity in their funds in normal and stressed conditions (taking into account any increase that might  6  6  Fender and Lewrick (2015) note that “when market volatility rises, standard risk assessment models will signal a market-maker inventory has become riskier. That may prompt the market-maker to further trim its holdings.