Financial Stability and Central Banks

The financial market events of the last nine months have raised a number of questions about our financial markets and institutions, about financial regulation, and about the central bank's role in credit markets.1 Some analyses have focused on the drying up of trading activity in certain structured finance products where the key observation is how abruptly liquidity conditions in a financial market can change. Others have focused on the underlying fundamentals of credit quality in these financial products, with a key observation being that, after the fact, it looks as though many decisions regarding the extension of credit yielded quite disappointing results. These two perspectives are clearly interrelated, since the loss of liquidity in asset-backed and related markets appears to have come about largely because of significant shifts in people's assessments of the underlying credit quality. Despite this intimate connection, emphasis on one or the other tends to lead to very different interpretations of recent events. An emphasis on liquidity is often associated with a view that financial market instability represents a breakdown in the functioning of markets, while an emphasis on credit quality suggests the view that such disruptions are simply the natural way that markets (even well-functioning markets) adjust to large changes in peoples' beliefs about fundamentals.