Financial innovation and the liquidity frontier

In the traditional model of financial intermediation, the sources and the process of liquidity creation through banks’ balance sheets were particularly clear. The robustness of liquidity in such a regime is essentially based on the quality of the banks’ assets and the credibility offered by the institutional framework within which they operate (deposit insurance, access to central bank money and more generally regulatory and prudential constraints). In the current financial system, with the perpetual supply of new capital and risk transfer instruments, endogenous liquidity sources have undeniably diversified and grown, but they appear to be less stable and reliable. Financial innovation, to an extent, may have let market participants believe that they could, on an enduring basis, escape from the monetary constraint (the need for genuine cash) and that they could make do with the liabilities issued by other institutions to meet their liquidity needs. However, market instruments can satisfy investors’ liquidity preference only as long as the state of confidence in the marketplace supports them. Liquidity preference, which is intimately linked to asset price expectations, is indeed liable to shift swiftly at times, and to bring about runs on the most certain forms of liquidity (bank money, and worse, central bank money). Ultimately, the liquidity of fi nancial assets depends on the trust that they can be redeemed on demand. Such trust is probably more difficult to ascertain in the market-based, highly securitised world. Still, crises may sometimes have educational virtues, and the turmoil of this summer has revealed some urgent needs to “robustify” the sources of liquidity in the system. It is now obvious that some additional suppliers of liquidity are needed in nearly absent secondary markets for complex structured credit products. This probably cannot be achieved without greater disclosure on the structures of investments among market participants. It is also clear that the containment of liquidity risk depends on the ability of fi nancial institutions to properly price complex products, in their regular risk management process as well as in times of crisis. The “liquidity frontier” cannot be pushed back indefi nitely. Those who, in the end, accept illiquidity in their balance sheet must clearly understand and control the risks they are taking on. Such illiquidity is more acceptable for investors with long time horizons, and who are not subject to creditors suddenly calling in their money at short notice. For others, larger liquidity buffers acting as an automatic stabiliser to smooth the financial cycle might be necessary to hedge their risk. Without such precautions, financial innovation could unduly extend the liquidity insurance implicitly expected of central banks. Yet, it is certainly not the role of a central bank to prompt market participants to rush into “not-so-reliable liabilities”.