RDP 2008-06: Promoting Liquidity: Why and How? 1. Introduction

As recent experience all too clearly demonstrates, liquid markets do not exist for all financial assets at all times. In some respects, this can be thought of as a market failure. The broad question that this paper examines is how public policy should best address this market failure, particularly in situations in which there is a potential threat to the stability of the financial system.

This question is of more than academic interest. The events of the past year have served as a stark reminder that a lack of liquidity in asset markets, particularly in times of increased uncertainty, can have significant implications for financial institutions, and the economy as a whole. In particular, the inability to sell assets and/or to raise funding can amplify disturbances in the financial system and contribute to significant losses in output. To the extent that these effects stem from a market failure, there is a public policy case for addressing that failure or, if that is not possible, at least addressing its consequences.

The discussion in this paper centres on two broad issues. The first is how best to promote asset market liquidity, and the second is the appropriate balance between the private and public sector in establishing arrangements for dealing with liquidity problems. A particular focus is to what extent the public sector should provide ‘systemic liquidity services’ to the private sector and, if it is to provide such services, how this should be done, and what conditions should apply to address moral hazard concerns and to ensure that new distortions are not introduced.

The paper is structured as follows. It begins by summarising the ‘first-best’ world of complete markets (and complete contracts) in which institutions are able to sell assets in liquid markets and generate liquidity when it is needed, and discusses how the real world differs from this benchmark. This is followed in Section 3 by a discussion of the various reasons why liquidity problems emerge in the real world. The following three sections then discuss possible ways of dealing with liquidity problems. These include: (i) reducing information asymmetries and improving financial market infrastructure; (ii) restricting the amount of maturity transformation undertaken by the banking sector; and (iii) the public sector providing various liquidity services to the private sector. This is followed in Section 7 with a general discussion of the policy issues.

The paper's main conclusions can be summarised as follows.

First, improvements in the financial infrastructure – including arrangements for disclosure and post-trade processing – have a role to play in limiting the sharp rise in information asymmetries that can occur when conditions in financial markets are strained and at turning points in the financial cycle. In doing so, these improvements can reduce the probability of liquidity drying up during these episodes. It is important, however, to be realistic about what can be achieved in this area, as information asymmetries are pervasive in the financial system, and are likely to remain so.

Second, recent events have shown up shortcomings in the way that financial institutions manage their own liquidity, and these shortcomings need addressing. However, the social costs of financial institutions fully self insuring against liquidity problems arising from market dislocation and/or the inability to sell assets on reasonable terms, are likely to be quite high. The public sector may be able to play a useful role here by providing a range of liquidity services to the private sector that help ameliorate the adverse effects on welfare of a lack of asset-market liquidity.

Third, if the public sector is to provide these liquidity services, then arrangements need to be put in place to ensure that the potential welfare gains from doing so are not undermined by financial institutions taking on greater risk than is warranted. Given that widespread liquidity problems are most likely to emerge at turning points in economic and financial cycles, one possibility is to strengthen the macroprudential dimension of supervision, with increased capital, and possibly liquidity, buffers being built up in the good times.