In other words, what happens when certain assets that are considered relatively safe, and in some cases are used as safe havens, are not considered as being that safe any more? The crisis has shown the importance of financial markets relying on liquid and safe assets to protect against systemic risk. Traditionally, the government bonds of advanced economies  4  BIS Review 126/2010  have played this role. What scenarios open up if advanced economies’ sovereign debt assets are no longer perceived as risk-free assets? How would this affect the functioning of financial markets? There is no doubt that there would be some direct spillover to all other assets. The riskiness of the global portfolio can be expected to rise more than proportionately. Indeed, if the public sector is itself over-leveraged, who can back up the public sector? 2 It can be expected that higher yields and lower asset prices would exert downward pressure on economic activity through increases in the costs of external finance, negative wealth effects and negative effects on confidence. 3 A world without default-free assets would have further implications for economic activity because these are the prototype of “information-insensitive” instruments, i.e. they serve as “money” and provide the basic functions of money when the opportunity cost of holding money becomes too high. 4 For instance, information-insensitive assets are an important source of collateral in financial markets. The disappearance of “good” collateral would reduce credit supply and thus impair economic activity.
I see this as a reasonable possibility, and therefore I think it might be possible that the decline in reserve balances has pushed up overnight rates a bit over time. 17 At this point, I see no evidence that we are at, or close to, the “steep” portion of the demand curve. 18 Let’s run through some places where evidence of such a possibility might be found. To begin with, if we were closing in on the “steep” part, I might have expected to see more above-IOR lending in the unsecured overnight markets, as at least some banks each day found themselves short of reserves and had to borrow them from another bank. In fact, the amount of such above-IOR lending remains low as a share of the overnight bank funding market, as shown in Figure 9. 19 I might also have expected to see shifts in bank payments behavior—for example, more daylight overdrafts or more effort by banks to “optimize” their payment flows— but I have not seen this either. But, most fundamentally, I might have observed a day-to-day relationship between shifts in the stock of reserves and overnight interest rates. Figure 10 shows a scatterplot of daily changes in reserve balances against daily changes in the spread between the IOR rate and the effective federal funds rate; there is no visible relationship. 16  The classic paper on this topic is Poole (1968).