First of all, when talking about liquidity, it is important to clarify that, in the field of central banking and monetary policy, there are at least four distinct definitions of liquidity – each with its own implications for policy-making. The first relates to “central bank liquidity”, which is provided to the money market in order to steer short-term interest rates. The second refers to the general “monetary policy stance”, as summarised by the level of policy interest rates. The third relates to “financial market” liquidity, which is defined as the ease with which large volumes of financial securities can be traded, without affecting the market price. The fourth refers to “ monetary liquidity”, which is defined in quantitative terms on the basis of monetary and financial aggregates. While all are important – indeed key – to monetary policy-making in the current environment of strong money and credit growth at the global level, I deem it necessary to say a few words on this last type of liquidity. I think you would agree that it is difficult to precisely measure global monetary liquidity. There seems to be no universally accepted definition of it among economists. Several measures have been suggested and they all differ in many respects. They can be based on different monetary and credit aggregates; they may vary according to geographical coverage; and finally, they can be constructed using different types of aggregation. Even more challenging is diagnosing at what point global monetary liquidity becomes excessive.
The flow of funds into the US was re-exported to the advanced economies, especially through the growing securitisation markets, and helped finance the rapid increases in house prices in the UK (Chart 2) and many other countries. And that internationalisation of markets was reflected also in the build up in our banks of portfolios of AAA-rated securities which offered a slightly better yield than traditional bonds and many of which were based on sub-prime assets. BIS Review 145/2008  1  So when losses emerged in sub-prime market, they not only hit US banks but ricocheted through the international financial system. Much of the commentary has focused on the structured credit losses in banks’ trading books and treasuries and they have certainly been large. But equally as important was the impact on the liability side of balance sheets. Banks had not only expanded their balance sheets too far, they had in the process become reliant on wholesale funding markets which had not been tested in a downturn. In the UK, the gap between customer lending and deposits moved from zero at the turn of the century to over £ billion in 2008 H1 (Chart 3). That proved a structural weakness when investors realised that the AAA label concealed substantial and uncertain risks and withdrew from the securitisation markets. Just as the origins of the crisis lay in global imbalances its effects are also global.