But we are also concerned with illiquidity in particular markets when it threatens the stability of the system as a whole. It is this concern that motivates the choice of assets we lend against in both normal and stressed conditions. A loss of liquidity in markets on which the banking system as a whole relies can magnify the mismatch between the maturity of assets and liabilities on banks’ balance sheets. A banking system in which large volumes of funding need to be renewed very frequently is a fragile one, vulnerable each day to a shock stemming from rumours and loss of confidence. And it is in those circumstances that a backstop is needed. The reason for it is not to support individual institutions. It is to avoid an unnecessary loss of confidence in the system as a whole. That backstop is central bank funding when private markets important to the stability of the system have temporarily closed. But central banks are not there to support liquidity in all markets at all times. They are not there to create a liquid market in all financial instruments that traders or some rocket scientist have dreamt up. Nor are they there to maintain indefinitely a market when changes in information or risk appetites make it more difficult to sustain a private market, as in some asset-backed security markets recently.
Since the onset of the crisis last summer, the way in which the tripartite arrangements work in practice has evolved considerably. The concept of a golden age in the relationship between the Bank and the banks is also far from the truth. Our relationship was described by David Kynaston, in his magisterial history of the City, as “surprisingly prickly”. In the 1920s the Chairman of the Midland Bank, Reginald McKenna, derided the Governor, Montagu Norman, as “an intellectual without an intellect”, and in turn Norman said about McKenna, “some people cannot avoid the limelight”. Since the crisis broke last August we too have had our differences, although more recently the close cooperation between the Bank of England and six of the largest banks in working through the details of our Special Liquidity Scheme was a model of effective collaboration. But perhaps we should not be surprised that sometimes our relationship is “prickly” because our interests do not always coincide. Banks are, entirely legitimately, concerned primarily with their commercial interest. The Bank of England is concerned with the interests of the UK economy as a whole. The two sets of interests are not always the same. BIS Review 75/2008  1  Where they may clash is over the use of our balance sheet. Companies which have misjudged risks or their business model should generally be allowed to fail to encourage prudent behaviour by others.