Furthermore, banks and supervisors should analyse in far greater depth how the wide range of liquidity risks may crystallise, separately or conjointly, in a stressed market environment. Rigorous stress testing should span individual, group-wide and market-wide scenarios. There is considerable scope for much better consideration of likely system-wide interactions, including the potential impact of “crowded trades” being unwound, the dynamics of liquidity hoarding, and the risks of signalling weakness and thus losing market confidence and funding lines. Stress scenarios should test properly for the outright closure of funding markets, and explore the possibility of several markets being shut concurrently. Finally, testing should consider longer horizons, to cater for the possibility that a liquidity crisis could persist for some time. These are just some of the areas which could be considered in more detail – clearly banks, supervisors and central banks all have much to learn with regards to the design of appropriately demanding and comprehensive stress scenarios. Recent events have also highlighted the need to devise considerably tougher contingency plans. Closer integration with stress tests will help firms develop more reliable and robust responses to future episodes of strain. Experience has highlighted the need to improve resilience to a sharp decline in market liquidity and to demonstrate that firms can survive the closure of one or more funding markets by ensuring that finance can be readily raised from a variety of sources. Consideration should clearly be given to boosting holdings of very high quality liquid assets that can provide reliable reserves under all conditions.
4  BIS Review 50/2008  Section IV: Lessons The recent turmoil has highlighted clear deficiencies in banks’ liquidity risk management. And it has also demonstrated that these deficiencies pose serious risks to financial stability and thus to the economy more broadly. To address this risk in the near term, central banks globally have provided additional liquidity to the banking system and emergency operations have been conducted to support Northern Rock and Bear Stearns. Additional liquidity has been provided at longer-term maturities to address the problem of funding an unexpected overhang of illiquid assets. The Bank’s recently launched Special Liquidity Scheme is enabling UK banks to liquefy a proportion of their outstanding stock of illiquid assets by swapping them for high quality liquid government securities, while ensuring that credit risks remain very clearly with the banks. That should ease current funding pressures. But in the medium term, it is clear that action is needed to strengthen the financial system’s defences to liquidity risk to limit the likelihood of any recurrence of the recent problems. Central banks globally are reviewing the lessons of the episode for their market operations, for example, to ensure that the usefulness of facilities is not undermined by perceptions of stigma that may be attached to a bank that uses them. But it is clear that primary responsibility for bolstering the defences lies with the banks themselves and that supervisory regimes for liquidity risk need reinforcing to support that process.