Market dysfunction and central bank tools

Episodes of severe financial market dysfunction eliciting large central bank responses have become more frequent and have occurred across a wider range of markets in recent decades. During such episodes, price discovery and matching between buyers and sellers are impaired and markets exhibit unstable dynamics. The March 2020 episode when the Covid-19 pandemic first hit global financial markets was one recent example. Funding markets at the core of the financial system experienced dysfunction, inducing a range of central bank actions to restore functioning. The events of March 2020 – against a backdrop of ongoing changes in market structure over recent decades that have altered the nature of liquidity provision across markets and increased vulnerabilities to shocks – underscored the need to strengthen resilience in the nonbank financial intermediation (NBFI) sector. In response, the Financial Stability Board (FSB) developed a major work programme to examine and, where appropriate, address specific issues contributing to amplification of the shock; enhance the understanding and monitoring of systemic risks in nonbank financial institutions; and assess policies to address systemic risks in these institutions. At the same time, the Markets Committee at the Bank for International Settlements has been reviewing the tools available to central banks to address market dysfunction, including an assessment of the potential benefits and costs of their use. As mentioned in the FSB progress report on "Enhancing the resilience of non-bank financial intermediation" in November 2021, the objective of this work was not to promote intervention methods, but rather to identify the potential range of possible tools available to address severe dysfunction episodes that threaten systemic stability, in ways that do not exacerbate moral hazard. The work aimed to do so by developing a framework for assessing interventions and the associated tools that central banks can use to address dysfunction in core local currency markets and evaluating the related trade-offs. Having a range of possible tools is especially important given ongoing changes in financial markets and because country- and shock-specific circumstances do not allow for a one size-fits-all approach. In considering possible tools, the work took note of the fact that central banks often have to decide on whether and how to respond to severe market dysfunction under conditions of extreme time pressure and uncertainty. A number of key insights emerge from that work.