Market liquidity depends not only on the presence of willing buyers and sellers but also on the underlying infrastructure, including market-making capacity and the system for clearing and settling financial transactions. Twenty years ago this fall, the 1987 stock market crash was significantly worsened by the inability of trade-processing systems to keep up with order flows, including orders resulting from program trading.

In its supervisory role, the Federal Reserve--like other bank regulators--attempts to ensure that individual banks maintain adequate liquidity on hand and make provision to raise additional funds quickly when the need arises. We must be wary of a subtle fallacy of composition, however. Even if each market participant holds a significant reserve of what--in normal times, at least--would be considered highly liquid assets, for the system as a whole the only truly liquid assets are cash and its equivalents. The quantity of cash assets in the system at a point in time is, in turn, essentially fixed, being determined directly or indirectly by the central bank.

The provision of liquidity by a central bank can help mitigate a financial crisis. However, central banks face a tradeoff when deciding to provide extraordinary liquidity support. A central bank that is too quick to act as liquidity provider of last resort risks inducing moral hazard; specifically, if market participants come to believe that the Federal Reserve or other central banks will take such measures whenever financial stress develops, financial institutions and their creditors would have less incentive to pursue suitable strategies for managing liquidity risk and more incentive to take such risks.

Although central banks should give careful consideration to their criteria for invoking extraordinary liquidity measures, the problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis. Recall Bagehot's advice: "The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times" (p. 24). Indeed, under the international Basel II capital accord, supervisors are expected to require that institutions have adequate processes in place to measure and manage risk, importantly including liquidity risk. In light of the recent experience, and following the recommendations of the President's Working Group on Financial Markets (2008), the Federal Reserve and other supervisors are reviewing their policies and guidance regarding liquidity risk management to determine what improvements can be made. In particular, future liquidity planning will have to take into account the possibility of a sudden loss of substantial amounts of secured financing. Of course, even the most carefully crafted regulations cannot ensure that liquidity crises will not happen again. But, if moral hazard is effectively mitigated, and if financial institutions and investors draw appropriate lessons from the recent experience about the need for strong liquidity risk management practices, the frequency and severity of future crises should be significantly reduced.

[L]iquidity risk management at the level of the firm, no matter how carefully done, can never fully protect against systemic events. In a sufficiently severe panic, funding problems will almost certainly arise and are likely to spread in unexpected ways. Only central banks are well positioned to offset the ensuing sharp decline in liquidity and credit provision by the private sector. They must be prepared to do so.

Another issue brought to the fore by the crisis is the need to better understand the determinants of liquidity in financial markets. The notion that financial assets can always be sold at prices close to their fundamental values is built into most economic analysis, and before the crisis, the liquidity of major markets was often taken for granted by financial market participants and regulators alike.

Well, I'm a little bit more sympathetic to central bankers now than I was 10 years ago.

I think it's very important to understand that my comments, both in my comment in the -- published comment a decade ago, as well as in my speech in 2002 about deflation, my main point was that a determined central bank can always do something about deflation. After all, inflation is a monetary phenomenon, the central bank can always create money, and so on.

In response to a question from Yomiuri Shimbun about his earlier criticism of the BOJ.

The banking sector overall also has substantially improved its liquidity position over the past few years. Indeed, large banks in the aggregate have more than doubled their holdings of cash and securities since 2009. Large banks have reduced their collective dependence on short-term wholesale funding, and many are flush with retail deposits, which tend to be a more stable funding source. Challenges on the liquidity front remain, however: Some large firms still rely heavily on wholesale short-term funding; and the liquidity needs of the banking system as a whole may become somewhat higher for a while as some of the securities issued under the Federal Deposit Insurance Corporation's Temporary Liquidity Guarantee Program come due, and as the unlimited insurance on noninterest-bearing transaction accounts expires at the end of the year. Nevertheless, over time, greater liquid asset positions and reduced dependence on wholesale short-term funding, together with more and better capital, will make the banking sector less susceptible to unexpected disruptions in short-term funding markets.

Stress-testing techniques can also be used in more-focused assessments of the banking sector's vulnerability to specific risks not captured in the main scenario, such as liquidity risk or interest rate risk. Like comprehensive stress tests, such focused exercises are an important element of our supervision of SIFIs. For example, supervisors are collecting detailed data on liquidity that help them compare firms' susceptibilities to various types of funding stresses and to evaluate firms' strategies for managing their liquidity. 

Although anecdotes of diminished liquidity abound, statistical evidence is harder to come by. Indeed, there is relatively little evidence of any deterioration in day-to-day liquidity. Traditional measures of liquidity, such as bid-asked spreads, are generally no higher than they were pre-crisis. Turnover, an alternative measure of day-to-day liquidity, is lower, but it is unclear whether this reflects changes in liquidity or perhaps changes in the composition of investors. The share of bonds owned by entities that tend to hold securities until maturity, such as mutual funds and insurance companies, has increased in recent years, which would lead turnover to decline even with no change in market liquidity. In some markets, the number of large trades has declined in frequency, which could signal reduced market depth and liquidity, but could also reflect a shift in market participants' preferences toward smaller trade sizes.

Finding a high-fidelity gauge of liquidity resilience is difficult, but there are a few measures that could be indicative, such as the frequency of spikes in bid-asked spreads, the one-month relative to the three-month swaption implied volatility, the volatility of volatility, and the size of the tails of price-change distributions for certain assets. We see some increases in the values of these indicators, which provide some evidence that liquidity may be less resilient than it had been previously. But this evidence is not particularly robust, and, given the limitations of the existing data, it is difficult to know the extent to which liquidity resilience may have declined.

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We are in the early stages of data-based analysis of possible recent changes in the resilience of market liquidity. An upcoming study of the October 15 event will shine some light on the functioning of the U.S. Treasury market, but there is still much we need to learn. More broadly, at the Board, we will closely monitor and investigate the extent of changes in the resilience of liquidity in important markets, while deepening our understanding of different contributors and how market participants are adapting.

[T]he Basel Committee is working on establishing international standards for liquidity requirements. There are two parts to this. The first is a requirement for a short-term liquidity buffer of sufficient size so that an institution that was shut out of the market for several weeks would still have sufficient liquidity to continue its operations unimpaired. The second is a liquidity standard that limits the degree of permissible maturity transformation—that is, the amount of short-term borrowing allowed to be used in the funding of long-term illiquid assets. Under these standards, a firm’s holdings of illiquid long-term assets would need to be funded mainly by equity or long-term debt.³

I would argue that progress on the liquidity front has not progressed as far as desired.First, many banks remain dependent on short-term funding to finance longer-term assets from counterparties that tend to flee at the first signs of distress. In particular, money market mutual funds remain vulnerable to runs. Such runs can occur even when the underlying risks remain negligible, making money market mutual funds a source of instability. Just a question from an investor about the fund manager’s exposures can cause the fund manager to withdraw funding from a counterparty. This may be market discipline, but it does not operate in a way that makes the financial system more stable.

Like the recent turmoil, each of these episodes had unique features. But there is an important common element to them—in each case, the event was associated with a drying up of liquidity. The most liquid assets are those that can be immediately used to discharge indebtedness: cash, bank reserves, and the like. When I say liquidity "dries up," I mean that market participants find it increasingly difficult to convert otherwise sound assets into these more liquid media of exchange. This would be the case if lenders are unwilling to accept the illiquid assets as collateral, or if dealers in these assets substantially widen bid-ask spreads, or if transactions in these securities simply cease to occur.

One way of thinking about these developments is that markets have become highly segmented. We do not see funds flowing in to take advantage of apparent profit opportunities with respect to distressed assets. If they were, they could ease liquidity pressures in these sectors and help keep some problems from spilling over into solvency concerns.

The priority focus should be figuring out new ways to enhance liquidity, reduce the fear that people have as counter-party risk
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We recently opened up our window to lend to what are called primary dealers. I fully expect that in return for that we will get regulatory authority to actually oversee those dealers, to make sure the people we're lending money to are adhering to the principles of good financial behavior.

As reported by Reuters

We are slowing down. We are in for a prolonged period of slowdown because of the excess speculation that took place in housing. ... and the fact that liquidity ... is not getting out to the system as regularly as it should.

As reported by Reuters.