Strengthening Regimes for Controlling Liquidity Risk: Some Lessons from the Recent Turmoil

Abstract

In this speech, Nigel Jenkinson, Executive Director for financial stability, emphasises that the management of liquidity risk is a key counterpart to banks' maturity transformation role. Over the decade prior to 2007 he explains how banks' vulnerability to liquidity risk increased as the rapid growth of structured products dispersed risk throughout the financial system but increased the system's interconnectedness and banks' reliance on wholesale markets as source of funding. He explains that common defences to a decline in the availability of liquidity (securitising illiquid assets, bidding for retail deposits, reducing assets) do not work well when all banks face funding pressures simultaneously as happened when financial market conditions deteriorated rapidly in August 2007 and wholesale term markets dried up. The last line of defence is to hold a buffer of high-quality liquid assets: the banking system has, however, reduced this buffer steadily over the past century. Jenkinson concludes with four recommendations: (1) banks and authorities develop better understanding regarding the vulnerability to liquidity risk particularly under stressed conditions; (2) banks develop more effective contingency funding plans; (3) banks support improved market functioning through better disclosure; and (4) supervision of liquidity risk is strengthened to ensure that banks' liquidity risk management is undertaken to a more robust standard that internalises some of the costs of a bank failure on the wider financial system.

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