Second, on market infrastructure and practices, establishing central counterparty especially for OTC transactions could have helped improve market infrastructure and lessen the risk of liquidity hoarding. And third, preapproved liquidity facilities by central bank, subject to certain prudential arrangements, for example, a satisfactory stress-test result, could also have helped central bank to inject liquidity more effectively and faster without creating a stigma issue to the requesting institution. And lastly, given all that has been said, how do we put all these together into a framework for policy. My tentative view is that, to be effective, a financial stability orientation policy has many crucial elements, with macroprudential being one of the components. To this end, an effective framework should include at least four policy pillars. The first is monetary policy, with a willingness for monetary policy to lean against the wind when the price stability objective of monetary policy is not compromised but there is a concern on financial stability. Second is a strong supervisory framework with vigilant implementation. By “strong”, I mean adopting a strengthened risk-based framework for microprudential supervision with a vigilant implementation. This crisis, to me, is more a crisis of supervision than crisis of regulation.
So it is no surprise that a risk factor which adversely affects one institution would simultaneously hurt another. With fair value accounting, everyone has to mark their positions to the same volatile market. A number of institutional investors also abide not to hold any assets below a certain credit rating, hence a hard cut-off. So when borderline assets get downgrade, all these institutional players have to liquidate their positions, all at the same time. Meanwhile, as VaR methodologies and risk management tools employed by different banks become increasingly converge, the results of the analysis also tend to converge. The main point is that when a risk factor moves adversely, these similarly exposed institutions incur the same direction of losses, whence their largely identical response actions further distress the market, thereby completing the feedback circuit. The second propagation channel in the form of network linkages between institutions presupposes that there exists prior bilateral relationships between financial institutions. A good example is in the clearing, payment, and settlement activities where the bilateral link is simply the amount that must be cleared, paid, or settled. But with real-time gross settlement,  4  BIS Review 130/2009  the vulnerability in this area featured very little in this crisis. Instead, in this crisis, the direct interbank liquidity/funding lines proved to be the most critical network of bilateral relationships. When one bank becomes illiquid, this triggers cascading illiquidity to all other banks that are direct counterparties, or counterparties to the counterparties.