When no trading takes place, no updated prices are quoted. This represents a challenge for institutions, auditors and regulators trying to mark assets and liabilities to the market. This has amplified the impact on the financial sector of the defaults on subprime mortgages. In the absence of pricing, the balance sheets of financial institutions holding such instruments became opaque. Uncertainty about the potential loss of other banks and about their own future liquidity needs has made banks reluctant to lend to each other. To the surprise and dismay of many, the extremely efficient and well-functioning money market ground to halt. Central banks had to step in and provide liquidity to the banking system. When money markets go into gridlock, it is appropriate for central banks to ease banks’ liquidity problems, but they should do so at a price that maintains the incentive to restore the smooth functioning of the market. Losses and evaporating liquidity then hit the capital base of many financial institutions. So far, the most severe problems have been local or national, like the British bank Northern Rock and the Norwegian brokerage house Terra Securities. These problems were resolved by means of national remedies. But with increased integration and the emergence of crossborder banks, sooner or later we are bound to encounter a problem in a bank or financial institution that may be systemically important in several countries (but not necessarily in the home country).
This increases the possibility that some investors – and issuers, for that matter – misunderstand the riskiness of an instrument. As a consequence, expected return may not appropriately reflect the true risk. When the true risk of an instrument starts to reveal itself, sharp corrections in the market may follow. The recent subprime crisis is one example of how new and complex instruments can give rise to global financial turmoil. Problems stemming from over-optimistic price expectations for the US housing market have spread to investors and financial institutions all over the world. The wide dispersion of the financial turmoil took many of us by surprise. Not to mention where problems turned up; in German Landesbanken, in large investment banks and in Norwegian hydro-electricity-rich municipalities, to name but a few. 1  Ben S. Bernanke (2006): ”Opening remarks” at ”The new economic geography: Effects and policy implications”, A symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming. 2  Alan Greenspan (2007): ”The age of turbulence”, The Penguin Press, New York. 2  BIS Review 14/2008  One lesson from the current financial turmoil is that the expected advantages of securitisation have been somewhat exaggerated. Securitisation was believed to make markets deeper and more liquid and – most importantly – to provide continuous pricing. Recent events have shown that this is not necessarily true for all markets at all times. In times of distress and uncertainty, some financial market segments can cease to function.