2  BIS Review 79/2005  3. How have firms reacted to these changes? The banking industry has, not surprisingly, responded to these changes by paying greater attention to liquidity risk management. And, as well as day-to-day management, banks have given more consideration to how they would cope with extreme or ‘tail’ events. Banks have developed, or are at least in the process of developing, sophisticated scenario analyses, and are assessing the contingency arrangements that would be required to respond to these scenarios. It is certainly encouraging to observe the determination with which many banks are addressing liquidity risk, and it is at the same time noteworthy how efficiency drivers have led many banking groups to take a more centralised approach to liquidity management. But, despite the progress that banks are making in addressing liquidity risk, the framework that underpins their contingency plans makes a number of assumptions, particularly regarding access to funding markets. There seems, for example, to be a widespread view that, whatever has happened to a firm’s access to wholesale unsecured funding, it will be able to borrow secured against good collateral. Lying behind this is probably an expectation that national authorities, and in particular central banks, will be ready to provide liquidity against good collateral in the event of the failure of one or more of the markets for secured borrowing.
Secondly, there are certain features of the prevailing financial and economic environment that give us pause for thought. Market prices are at historically unusual levels: real and nominal returns on risk free assets are low and credit spreads are tight, both in traditional and structured products. It is of course hard to say definitively the extent to which today’s markets are merely reflecting changed fundamentals. But it is quite possible that some investors have unwittingly taken on higher levels of risk in pursuit of what they would consider to be “normal” levels of return. And it is certainly prudent to plan for the possibility of a sharp reversion of prices to historically more normal levels (or even beyond them, given the tendency of markets to overshoot). There could be a period of impaired market liquidity during any such correction. One could imagine a number of potential catalysts for such a correction, ranging from a geo-political event to some form of major operational disruption. The Bank concurs with the widely held view that the growth of markets in risk transfer should contribute to greater financial stability, by allowing a more efficient dispersion of risks. But the depth and reliability of the more recently developed markets in risk under stressed conditions has not yet been fully tested. Moreover, risk transfer markets can, and probably at present do make the ultimate destination of risks more opaque. This hampers our ability to assess the overall stability of the financial system, and, potentially, to react effectively in a crisis.