The volume of term lending transactions has declined significantly, with few buyers or sellers of term funds. I can suggest several reasons.

First, many potential suppliers of funds have become increasingly concerned about their capital position, causing them to look for opportunities to shrink (or slow the growth of) assets on their balance sheets, in order to maintain a desirable capital-to-assets ratio. Since unsecured inter-bank lending provides relatively low returns and has little benefit in terms of relationships, banks may prefer to use their balance sheet to fund higher-returning assets that advance long-term customer relationships.

Second, as the uncertainty over asset valuations has increased, banks have become reluctant to take on significant counterparty risk to financial institutions – particularly with those that have significant exposure to complex financial instruments.

Third, many potential borrowers are reluctant to buy term funds at much higher rates than can be obtained overnight, for fear that they may signal to competitors that they have liquidity concerns. However, when the counterparty is a central bank, financial institutions have been quite willing to buy term funding, sometimes at rates higher than they would expect if they were to borrow funds overnight.

Asked if there is any way to pump liquidity into the markets without reinforcing commodities speculation, Rosengren said that, "Unfortunately, we don't have much control over where the money goes after we push it into the market."

The purpose of the liquidity provisioning "has not been to cause commodity speculation," he said. "I think there have been some very beneficial things to come out of liquidity moves."

From Q&A as reported by Market News International

"There does seem to be something different” in bond markets right now, the official said. “Something does seem to have changed” in terms of things like the ability of a market participant to easily execute a large trade, he said.

As it now stands, “I don’t think there is at this point a very precise and convincing explanation for exactly what has happened,” Mr. Tarullo said. He noted signs of fragility could be tied to regulatory changes, the rise of high frequency trading and firms’ willingness to engage in the market as potential drivers of current market conditions.

From the point of view of authorities, “there may be action needed at the end of the day. But I wouldn’t jump the conclusion a bigger balance sheet equates to financial stability,” Mr. Tarullo said.

I think most of us would acknowledge, upon reflection, that a good bit has been done, or at least put in motion, to counteract the problems of too-big-to-fail and systemic risk more generally. At the same time, I believe that more is needed, particularly in addressing the risks posed by short-term wholesale funding markets. 

...

As you can tell from my description, many of these reforms are still being refined or are still in the process of implementation. The rather deliberate pace--occasioned as it is by the rather complicated domestic and international decisionmaking processes--may be obscuring the significance of what will be far-reaching change in the regulation of financial firms and markets. Indeed, even without full implementation of all the new regulations, the Federal Reserve has already used its stress-test and capital-planning exercises to prompt a doubling in the last four years of the common equity capital of the nation's 18 largest bank holding companies, which hold more than 70 percent of the total assets of all U.S. bank holding companies. The weighted tier 1 common equity ratio, which compares high-quality capital to risk-weighted assets, of these 18 firms rose from 5.6 percent at the end of 2008 to 11.3 percent in the fourth quarter of 2012, reflecting an increase in tier 1 common equity from $393 billion to $792 billion during the same period.

In recent quarters, we witnessed very strong credit markets, bulging pipelines for leveraged loan and high-yield bond issuance, and near-record low credit spreads...

Fund managers of private pools of capital seized upon this opportunity to acquire more-permanent sources of capital: extending lock-up periods; using retail platforms and co-investment funds to increase ‘stickiness’ of contributed capital; securing greater financing flexibility from prime brokers; accessing the private placement markets; and selling public shares of limited and general partnership interests to new investors; to name just a few.

Therefore, I wish to advance a simple proposition: Liquidity is confidence. That is, powerful liquidity in the U.S. capital markets is evidenced when the economic outcomes are believed to be benign. When the “tail” outcomes are either highly improbable or, at the very least, subject to reasonably precise measurement, the conditions are ripe for liquidity to be plentiful.

Indeed, when different measures of the money supply were established, it was with an eye toward determining the liquidity of the underlying assets; as an example, components of M1 were considered more liquid than those in M2. It is in this sense that some observers view the stock of money as a measure of liquidity, and changes in these measures as roughly equivalent to changes in liquidity. I doubt, however, that traditional monetary aggregates can adequately capture the form and structure of liquidity many observe in the financial markets today.

Liquidity exists when investors are confident in their ability to transact and where risks are quantifiable. Moreover, liquidity exists when investors are creditworthy. When considered in terms of confidence, liquidity conditions can be assessed through the risk premiums on financial assets and the magnitude of capital flows. In general, high liquidity is generally accompanied by low risk premiums. Investors’ confidence in risk measures is greater when the perceived quantity and variance of risks are low.

During the past few decades--particularly the last few years--we have witnessed an escalating supply of new financial instruments scarcely able to match surging demand. Through the technique of unbundling risks--dividing them by category and tranche--financial instruments proliferated to enable risks to be borne by those most willing to accept them. And with the benefit of ample liquidity, which I described in previous remarks as broadly equal to confidence, financial products quickly found deep markets, ensuring robust trading.

“[L]iquidity” in the sense of “trading liquidity” reflects the ability to transact quickly without exerting a material effect on prices. Underlying this concept is the fact that although the many buyers and sellers have different views on the most likely outcomes, the distributions of possible outcomes for which they demand risk-based compensation can be quantified. Liquidity exists when investors are confident and willing to take risks. Liquidity, then, can be viewed as confidence on the part of buyers and sellers of securities. By disaggregating a security into its constituent risk components, financial innovation can unlock this liquidity.

Strong global economic performance provides another important support for the high liquidity and levels of confidence in today’s capital markets. Many economies have achieved a marked reduction in the volatility of real output and core inflation in the past twenty years or so. Liquidity can flourish if investors interpret strong performance to mean that future economic outcomes will be benign and that “tail” realizations are either highly improbable or, at the very least, quantifiable and, hence, can be traded upon.

Perhaps because of more complete markets, shocks to liquidity are less likely to become self-fulfilling and less likely to impose more lasting damage. That hypothesis seems particularly credible when the shock is based neither on rapidly changing economic fundamentals nor a genuine breakdown in market infrastructure. In the recent episode [in Febryary 2007], opportunistic capital apparently viewed large movements in asset prices as trading opportunities. Or, perhaps, striking as it was, we have not yet witnessed a scenario that subjects the latest product innovations and behavior of market participants to a sufficiently stringent stress test.

There is little doubt, then, that liquidity in most financial markets is high today and that investors seem willing to take risks, even at today’s market-prevailing prices. In the United States, term premiums on long-term Treasury yields are very low, corporate bonds appear to be nearly “priced for perfection,” and stock prices are setting new records. Credit markets are highly accommodative for issuers, and the volume of loans to finance highly leveraged transactions is escalating rapidly. These prices, terms and credit conditions may reflect solid economic fundamentals--low output and inflation uncertainty, healthy corporate balance sheets, and corporate profits that exceed market expectations--and if so, they may help to ease the effects of fluctuations in liquidity should they occur. The prices and conditions may also reflect increased appetite for risk; or, far less auspiciously, they may be indicative of investor overconfidence.

Some market participants tell me that the very low bond default rates seen recently, realized and expected, are themselves a reflection of liquidity. That is, excess market liquidity may have allowed less than creditworthy firms to refinance their obligations, thereby only deferring their financial difficulties. Other observers note the rise in the second half of last year in the share of new bond issuance that is rated highly speculative, and an increase in purchase and debt-multiples for leveraged buyouts, suggesting some pickup in risk-taking that may be indicative of overconfidence.

The consequences of the liquidity shock of 2007 on the financial markets and the real economy are still playing out in real time. It is premature to delineate lessons learned with complete assurance. The facts, nonetheless, can perhaps be placed in some narrative context, drawing on the experience of prior bouts of financial instability. History, of course, is far from a perfect teacher. After all, history does not repeat itself; it only appears to do so. In that regard, the causes and consequences of market turmoil are still insufficiently understood for the end of history to be declared