These buffers would help protect the firm against having to liquidate assets under duress, and would therefore help prevent the probability distribution from sliding left toward the zero line in Figure 2. But there is a cost to the firm from holding greater liquidity buffers in terms of lower returns on capital. So, requiring greater liquidity buffers would also tend to drive up intermediation costs. And, just as in the case of higher capital requirements, banks could respond by taking greater risks. Third, regulators could implement changes that would reduce the degree of dispersion in the potential value of a firm, pushing the right tail of the distribution in Figure 2 to the left. For example, we could require greater transparency about the composition and quality of the firm’s assets and liabilities. Or, regulators could increase transparency by forcing greater disclosure of the sale price of assets and/or by pushing for greater homogeneity and price  6  This problem has been largely addressed in the banking sector by deposit insurance and by providing access to lender of last resort facilities. In addition, supervisory and reporting requirements address transparency issues. 6  BIS Review 143/2009  discovery for products such as OTC derivatives. We could improve the quality of regulation and supervision, which would increase confidence in regulatory measures of capital and financial firms’ soundness. Fourth, the central bank could provide a liquidity backstop to solvent firms.
This is especially the case if the collateral is lower quality and markets are already illiquid. Moreover, if creditors are left with the collateral instead of being repaid, fear of widespread collateral liquidation might further erode collateral values. If investors respond by seeking more collateral to ensure they will be secured – that is, that they will be made whole in a liquidation scenario – the firm may run out of high-quality collateral that the firm can borrow against. This is a significant risk when a financial firm is highly leveraged and equity is only a very small proportion of total assets.5 The risks of liquidity crises are also exacerbated by some structural sources of instability in the financial system. Some of these sources are endemic to the nature of the financial intermediation process and banking. Others are more specific to the idiosyncratic features of our particular system. Both types deserve attention because they tend to amplify the pressures that lead to liquidity runs. Turning first to the more inherent sources of instability, there are at least two that are worthy of mention. The first instability stems from the fact that most financial firms engage in maturity transformation – the maturity of their assets is longer than the maturity of their liabilities.