Liquidity can mean many different things. One dimension of liquidity is the availability of credit or the ease with which institutions can borrow or take on leverage. This is generally referred to as funding liquidity.

Another dimension of liquidity is the ease with which market participants can transact, or the ability of markets to absorb large purchases or sales without much effect on prices. This is what is generally called market liquidity.

When market liquidity and funding seem abundant, this is likely to be observable in things we can measure, like interest rates and credit spreads. And when liquidity ebbs, the effect is conspicuous in a range of observable market prices and volumes. But we do not have, and probably never will have, a set of indicators that offers the promise of predicting when liquidity conditions will reverse, or when markets are particularly vulnerable to a more acute decline in liquidity.

In this sense, liquidity is like confidence. And, like confidence, liquidity plays a critical role both in establishing the conditions than can lead to a financial shock, and in determining whether that shock becomes acute, threatening broader damage to the functioning of financial and credit markets.

The proliferation of credit risk transfer instruments was driven in part by an assumption of frictionless, uninterrupted liquidity. This left credit and funding markets more vulnerable when liquidity receded. Banks and other financial institutions lent substantial amounts of money on the assumption that they would be able to distribute that risk easily into liquid markets. A sizable fraction of long-term assets—assets with exposure to different forms of credit risk—ended up in vehicles financed with very short-term liabilities and was placed with investors and funds that were also exposed to liquidity risk.

By allowing institutions to finance with the central bank assets they could no longer finance as easily in the market, we have reduced the need for them to take other actions, such as selling other assets into distressed markets, or withdrawing credit lines extended to other financial institutions, that would have amplified pressures in markets. These measures—the Term Auction Facility and swap arrangements—have had some success in mitigating market pressures, in part by providing a form of insurance against future stress. We now have in place a cooperative framework for liquidity provision among the major central banks. And we have considerable flexibility to adjust the dimensions of these liquidity tools. We will keep them in place as long as necessary, and continue to adapt them where we see a compelling case to do so.

Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls. Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable to meet their obligations and their counterparties responded by liquidating the collateral they held. This put downward pressure on asset prices and increased price volatility. Dealers raised margins further to compensate for heightened volatility and reduced liquidity. This, in turn, put more pressure on other leveraged investors. A self-reinforcing downward spiral of higher haircuts forced sales, lower prices, higher volatility and still lower prices.

This dynamic poses a number of risks to the functioning of the financial system. It reduces the effectiveness of monetary policy, as the widening in spreads and risk premia worked to offset part of the reduction in the fed funds rate. Contagion spreads, transmitting waves of distress to other markets ...

The most important risk is systemic: if this dynamic continues unabated, the result would be a greater probability of widespread insolvencies, severe and protracted damage to the financial system and, ultimately, to the economy as a whole. This is not theoretical risk, and it is not something that the market can solve on its own. It carries the risk of significant damage to economic activity. Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education, and the expenses of everyday life, lower value of retirement savings and rising unemployment.

My own view is that we should consider hard-wiring more sprinkler systems into financial markets and insitutions. One obvious area to look is whether we can improve the risk-based capital approach embodied in Basel II. If capital is to function effectively, it needs to rise as risks increase and be depleted as losses materialize. I think we need to look especially at the procyclical behavior of leverage that we have observed in some large financial institutions, In addition, I believe there may be merit in considering formal liquidity requirements, and perhaps loan-to-value ratios for banks and other financial institutions, especially the large institutions that provide liquidity and risk-management products to other financial institutions and financial markets. I also think that it is time we extinguish some of the off-balance sheet fictions that have developed to excess in recent years.

In the area of supervision, I would offer two thoughts. First, the current financial crisis reinforces the importance for a central bank to have accurate and timely information on the conditions of all institutions that might make use of its liquidity facilities. Personally, I believe this is most likely to happen when the central bank has ongoing supervisory responsibilities for all institutions eligible to use its liquidity facilities. Thus, I am not a supporter of the removal of supervisory responsibilities from central banks as has happened in a number of countries. If this separation is in effect, or segmented as it is in the United States, I believe a central bank must have the legal authority to require this information from the supervisory agency on terms set by the central bank. A voluntary exchange of this information is no more likely to be effective in a financial context than it was in the U.S. intelligence community prior to 9/11.

We have had this financial crisis; I think on balance as we at the Federal Reserve have provided liquidity to the marketplace, it's my thought that we have stabilized things.

This allows the other policy choices, the tax cut ... monetary policy that's in place, to strengthen the economy as it goes through the course of the year. And in that context then, our big challenge will be to make sure that we bring inflation in check and make sure that we do not repeat some of the experiences we had in the late 70s and early 80s when inflation became far too high.

As reported by Reuters.

Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if such demands are not satisfied, financial markets will tighten at exactly the wrong moment. This was, for example, an important consideration after the stock market crash of 1987, when demand for liquid deposits raised the demand for reserves held at the Fed; and again after 9/11, when the loss of life and destruction of infrastructure impeded the flow of credit and liquidity.

Second, we must determine whether the stance of monetary policy should be adjusted to counteract the effects on the economy of tighter credit supplies and other knock-on effects of financial instability. As a result, meetings of the Federal Open Market Committee (FOMC), often in conference calls if the situation is developing rapidly, have been an element in almost every crisis response. Those meetings allow us to gather and share information about the extent of financial instability and its effects on markets and the economy as we discuss the appropriate policy response.

With more risk traded in markets and more participants managing that risk through portfolio adjustments made in markets, the importance of market liquidity has increased and the potential knock-on effects from an erosion of liquidity have multiplied. We could face situations in which asset price movements are exacerbated by the actions of market participants, including dynamic hedging strategies or forced liquidations of assets to meet margin calls, and those asset price movements could feed back onto the economy.

During times of systemwide stress, such as the one we are currently experiencing, significant liquidity demands can emanate from both the asset and the liability side of a bank's balance sheet.  For example, we have recently seen how unanticipated draws on liquidity facilities by structured investment vehicles, commercial paper conduits, and others can lead to significant growth in bank assets.  Moreover, some organizations have also encountered difficulty in selling whole loans or securitizing assets as planned.  There were also cases in which reputational concerns have prompted banks or their affiliates to provide liquidity support to a vehicle or to incorporate some of the vehicle's assets onto the bank's balance sheet, even when the bank had no legal obligation to do so.  In a few cases, these unexpected increases in the balance sheet created some pressures on capital ratios, even when capital levels remained unchanged. 

Liquidity risk is a familiar risk to banks, but it has appeared in somewhat new forms recently. While the originate-to-distribute model aims to move exposures off of banks' balance sheets, the risk remains that a sudden closing of securitization markets can force a bank to hold and fund exposures that it had originated with the intent to distribute. ...

Concentration risk is another familiar risk that is appearing in a new form. Banks have always had to worry about lending too much to one borrower, one industry, or one geographic region. But as smaller banks hold more of their balance sheet in types of loans that are difficult to securitize, concentration risks can develop. Concentrations of commercial real estate exposures are currently quite high at some smaller banks. This has the potential to make the banking sector much more sensitive to a downturn in the commercial real estate market.

To protect their capital and liquidity, banks and other financial market participants are addressing the weaknesses revealed by market developments by becoming much more careful about the risks they are taking. This is a necessary process, but it has been a difficult one as well; it is reducing the values of some assets and tightening credit cost and availability across a wide range of instruments and counterparties, despite considerable easing in the stance of monetary policy. It is this tightening that is accentuating the downside risks for the economy as a whole. And in some sectors, as lenders seek protection against perceived downside risks, it is probably going further than is necessary to foster financial stability in the long run.

So we must worry about excessive leverage and susceptibility to runs not only at banks but also at securities firms. To be sure, investment banks are still different in many ways from commercial banks. Among other things, their assets are mostly marketable and their borrowing mostly secured. Ordinarily, this should protect them from liquidity concerns. But we learned that short-term securities markets can suddenly seize up because of a loss of investor confidence, such as in the unusual circumstances building over the past six months or so. And investment banks had no safety net to discourage runs or to fall back on if runs occurred. Securities firms have been traditionally managed to a standard of surviving for one year without access to unsecured funding. The recent market turmoil has taught us that this is not adequate, because short-term secured funding, which these firms heavily rely upon, also can become impaired.

With many securities markets not functioning well, with the funding of investment banks threatened, and with commercial banks unable and unwilling to fill the gap, the Federal Reserve exercised emergency powers to extend the liquidity safety net of the discount window to the primary dealers.³ Our goal was to forestall substantial damage to the financial markets and the economy. Given the changes to financial markets and banking that we've been discussing this morning, a pressing public policy issue is what kind of liquidity backstop the central bank ought to supply to these institutions. And, assuming that some backstop is considered necessary because under some circumstances a run on an investment bank can threaten financial and economic stability, an associated issue is what sorts of regulations are required to make the financial system more resilient and to avoid excessive reliance on any such facility and the erosion of private-sector discipline.

...

Whatever type of backstop is put in place, in my view greater regulatory attention will need to be devoted to the liquidity risk-management policies and practices of major investment banks. In particular, these firms will need to have robust contingency plans for situations in which their access to short-term secured funding also becomes impaired. Commercial banks should meet the same requirement. Implementation of such plans is likely to entail substitution of longer-term secured or unsecured financing for overnight secured financing. Because those longer-term funding sources will tend to be more costly, both investment banks and commercial banks are likely to conclude that it is more profitable to operate with less leverage than heretofore. No doubt their internalization of the costs of potential liquidity shocks will be costly to their shareholders, and a portion of the costs likely will be passed on to other borrowers and lenders. But a financial system with less leverage at its core will be a more stable and resilient system, and recent experience has driven home the very real costs of financial instability.

In particular, the public authorities must address a difficult yet very important question: To what degree should entities with access to central bank credit be permitted to rely on that access to meet potential liquidity demands? Central bank liquidity facilities are intended to permit those with access to hold smaller liquidity buffers, which allows them to fund more longer-term assets and thereby promotes capital formation and economic growth. At the same time, however, the existence of central bank credit facilities can so undermine incentives for maintaining liquidity buffers that institutions hold more longer-term assets than is socially desirable and thereby pose excessive risk to themselves and the financial system.