Yesterday, the Financial Stability Board (FSB) released a report: Holistic Review of the March Market Turmoil (Report). It contains lots of really interesting information and is well worth a read (for a quick overview, there’s an Executive Summary and a two minute YouTube video of Randal K. Quarles, FSB Chair and a Governor of the Federal Reserve System, discussing the Report).
I thought its emphasis on the increasingly central role of market liquidity to financial market resilience particularly important. Today, both the traditional, highly regulated banking system and the market-based credit system provide credit to the economy. These systems are interconnected and roughly equivalent in size. Although the market-based credit system – non-bank financial intermediation (NBFI) – looks, smells, and acts like banking, it is not similarly regulated nor does it have access to deposit insurance or the Federal Reserve’s lender of last resort liquidity facility. Nevertheless, in the financial crisis of 2007-09 and this past March, the Federal Reserve provided extraordinary liquidity and other support to the NBFI to promote financial stability and address bank-like runs.
On p.2, the Report notes that “The need to intervene in such a substantial way has meant that central banks had to take on material financial risk. This could lead to moral hazard issues in the future, to the extent that markets do not fully internalise their own liquidity risk in anticipation of future central bank interventions in times of stress.” The Report explains on p.33 just how extensive this recent central bank support was: “Overall, these measures lead to a US$7 trillion increase in G7 central bank assets in just eight months (Graph 5.1). In contrast, G7 central bank assets only rose by about US$3 trillion in the year following the collapse of Lehman Brothers in 2008.”
The market-based credit system underprices liquidity risk. Measures must be taken to address this significant issue. As I wrote in The Federal Reserve As Last Resort (footnotes removed from quote):
Liquidity is not free. Liquidity risk is one of the fundamental risks in financial markets. All else being equal, liquid financial assets are less risky than illiquid ones and, therefore, worth more. Financial investors generally expect to receive a "liquidity premium" for illiquid financial assets. In the past, however, both economic and financial theories have sometimes treated liquidity as costless. And international financial institutions have long mismanaged and mispriced liquidity risk. Not surprisingly, liquidity assistance emerged as one of the most sought-after remedies provided by the Federal Reserve and central banks around the world during the financial crisis.
On p.50, the Report states that “Taken together, the measures introduced [by central banks] essentially removed risk from investors and transferred it to the balance sheet of central banks and hence of the public sector as a whole.” I’m excited for the FSB’s upcoming “work programme” on NBFI (see p.3 of the Report for details), and hope that in the future, investors will be required to retain more of their contracted for risk and that the resilience of this sector greatly improves.