In principle, prudential regulation of institutions with access to central bank credit can limit moral hazard and induce institutions to hold amounts of longer-term assets and liquid assets that are socially desirable. In practice, however, this requires difficult and necessarily somewhat arbitrary judgments about the types of liquidity stress scenarios that institutions should plan to confront without access to central bank credit and, correspondingly, those scenarios in which institutions in sound financial condition can appropriately rely on central bank credit.

While liquidity pressures in banking and financial markets have eased of late, we do recognize that institutions must prepare themselves for the possibility that liquidity problems could return, either market-wide or at an individual institution.

I’m pleased to be here today to participate in this discussion about liquidity and monetary policy. Apparently many others are having a similar discussion--a quick search of LexisNexis turned up 2,795 separate articles in the past six months alone that mentioned the word “liquidity” in the context of its abundance in financial markets. The use of the term liquidity in these articles spans a wide variety of meanings--perhaps 2,795 of them!

Rather than grapple with the definition of the rather slippery concept of liquidity in my short remarks here, I will focus on aspects of global financial markets that many analysts associate with liquidity and that are particularly relevant for monetary policy--namely, the relatively low level of long-term interest rates in both real and nominal terms and the resulting relatively flat slope of yield curves around the world.

In the simplified world of an introductory economics class, a market brings together the potential buyers and sellers of a product to negotiate prices and quantities... While this stripped-down story is remarkably powerful in its essential predictions about the behavior of markets and economic agents, it leaves the operation of the market itself as a mystery.  Any real-world market must deal with at least two fundamental questions:  first, how do the buyers and sellers find one another?  And second, how can buyers be assured that sellers will deliver as promised, and that the goods will be of the quality and value that the buyer expects?  To understand how markets deal with the fundamental issues of transaction costs and information costs is an important and enduring challenge for economists.

Stress testing and scenario analysis can provide valuable information about the potential risks of complex investment products, but in many cases application of such tools to structured investment vehicles appears to have been inadequate.  For example, some bankers did not necessarily explore scenarios in which these vehicles' credit ratings could be downgraded... Notably, most of these vehicles mirrored the liquidity mismatch that exists at most banks in that they contained longer-term assets funded by shorter-term liabilities, but it is not clear that banks fully considered the potential funding-liquidity problems that these vehicles could face if there were sudden market moves or if perceptions of credit risk changed.  And they may not have fully explored scenarios in which problems with these vehicles could have ramifications for the bank, such as the need to provide liquidity support to the vehicle or to incorporate some of the vehicle's assets onto the bank's balance sheet. 

No matter what the short-term benefits of that action were, or the other credit market interventions that we have undertaken, there is undoubtedly a risk of adverse incentive effects down the road and perhaps even in the near term as well.

From comments to press, as reported by Reuters

A week ago Sunday, the acquisition of Bear Stearns by JPMorgan Chase was announced. Earlier this week, the deal was changed from the original $2 per share to $10 per share, and certain specifics were adjusted. To facilitate this transaction, the New York Fed—through a limited liability company formed for this purpose—will take control of a portfolio of assets valued at $30 billion as of March 14. JPMorgan Chase will bear the first $1 billion of any realized losses in this portfolio, and any gains will accrue to the New York Fed. The arrangement was undertaken with the support of the U.S. Treasury.

This action was taken to bolster market liquidity and promote orderly functioning of short-term funding and credit risk markets.

Another theme that emerges is liquidity risk. A fundamental assumption of many risk management procedures is the ability to get out of a position or to hedge it. Events in Asia demonstrated once again that assumptions about liquidity in normal markets rarely hold in more volatile ones. This argues both for a reassessment of the assumptions themselves and for more careful and fundamental thinking about liquidity risk in risk management procedures.

Although post-crisis regulatory changes have likely increased the costs of market making, markets were already undergoing dramatic changes well before the crisis. High-frequency and algorithmic trading firms already accounted for a large and growing share of transactions in the interdealer market, altering the speed and nature of market making. As traditional dealers have lost market share, they have sought to remain competitive by internalizing a greater share of their customer trades, finding matches between their own customers and keeping those trades off the public interdealer markets. But internalization does not eliminate the need for a public market, which is where price discovery mainly occurs. Dealers need to place the orders that they cannot internalize onto that market, and at times of market stress such as on October 15, they will likely need to put most of their orders onto the public market.

And I would also say it’s clear that market depth is less, meaning the ability to transact in large quantities is much less in fixed income markets in some fixed income markets than it was before the crisis. There are a variety of factors that are driving that. One of them is smaller risk appetite by firms. They will proudly show you how much less risk they are taking. Another is this advancing technology and another is regulation. It is really hard to disentangle the effects of those three.

So the question is, and I don’t really know the answer, but the question is -- is are we at -- is that a bad equilibrium. You know we got safer core, safe financial markets, large financial institutions, much better capitalized and much less risky. But you have got less depth in bond markets and the issue that some of the asset managers may be, investors in mutual funds for example, may be over estimating the liquidity that they’ll really have in a stressed environment.

...

I don’t know. It is not obvious to me that that is a worse equilibrium that we had without those innovations. In any case I don’t think those three forces that I mentioned technology, risk aversion and regulations. I don’t think it is obvious that those are going to change at all. We might at the margin tinker with them but those are things that are probably going to remain.

It is certainly true that market depth is less, and inventories are much less than they were before the crisis. It is also probably true that systematically the cost of supplying liquidity and the cost of holding those assets was underestimated, inappropriately so, before the crisis. So, some of that is good. And again, if you sit down, as I have, with many of the large firms some of them will tell you, “this isn’t you, this is us. We are looking at our risk in a completely different way than we did before the crisis. And this was our risk before the crisis and this is our risk now.”

So it is not obvious it is all because of regulation. I do think there are many other factors. The right question is this, is it a problem? It is certainly possible, it is intuitively likely, that with lower market depth there would be higher volatility for a quantum of news or a shock of some kind. I think that is right.

Again, the question is, is this a better equilibrium? That is something that requires some thought, it is something that we at the Fed are looking very carefully at right now as are many others around the world.

My view is that these [post-crisis] regulations are new, and we should be willing to adjust them as we learn. That said, we should also recognize that some reduction in market liquidity is a cost worth paying in helping to make the overall financial system significantly safer.

In our research, we looked at what happened to homeowners who used subprime loans to buy their homes and found that five years later, 90 percent were either still in their house or had profitably sold it.  While our research also shows that number will likely be lower for the most recent vintages, which already exhibit elevated defaults, most subprime buyers have a positive experience with homeownership. So, perhaps the most critical issue is that financing that supports responsible subprime lending continues, despite recent problems. Since the broker channel has been disrupted, as described earlier, I believe there is an opportunity for commercial and savings banks to help provide liquidity in this market. Most commercial and savings banks were not involved in originating subprime mortgages and are well capitalized, and may have profitable opportunities to explore in this market.

Should we view the current developments and concerns in credit markets as a wholesale reassessment (or repricing) of risk by investors, and are the recent problems related to securitizing assets likely to have a longer lasting impact on the economy or financial markets?

I think the answer is no, investors are not reassessing risk in a wholesale way. Consider that a variety of assets that normally are impacted by investor desire for risk reduction have shown little reaction to current problems. For example, if one looks at emerging market debt, or stock prices in emerging economies, the current problems have left little trace in the data. Prices for stocks in many emerging markets are close to or at their highs for the year.

By contrast after September 11, 2001 and during the problems triggered by Long-Term Capital Management, stocks in many emerging markets fell sharply. Similarly, emerging market debt has shown only a modest widening of spreads. Following the September 11 attacks and during the Long-Term Capital Management problems, emerging market interest rates rose sharply.

Short-term debt markets, where relatively low risk financial assets are traded primarily between large financial institutions, are experiencing significantly reduced volumes and unusually large spreads. This is consistent with liquidity problems rather than a change in the willingness to hold risky assets in general.

The past two months have been quite unusual for financial markets. Short-term liquidity has been disrupted for almost two months, as investors have reevaluated the securitization process. I am hopeful that with appropriate underwriting, the securitization process and the ABCP [asset-backed commercial paper] will continue to be a source of financing for a wide range of assets.

First, some financial products were not well designed to withstand liquidity problems. To avoid paying banks fees to provide a liquidity backstop, many financial products of recent vintage included provisions to force liquidation when necessary to insure payment to the holders of the higher-graded securities (or slices of securities). This structure was used, for example, by structured investment vehicles (SIVs)

13. However, due to the recent financial stress, assets of SIVs could not be liquidated at prices felt to be reasonable. Broadly speaking, products should be structured to better weather periods of illiquidity, and ratings models should take better account of liquidity risk.