BIS report: build liquidity co‑operation early to prepare for crisis

Central banks need to act early to build networks of co-operation and source liquidity, before the next financial crisis strikes, a report by a Bank for International Settlements committee says.

The report, penned by the Committee on the Global Financial System (CGFS) and published today (April 6), seeks to draw together best practice on liquidity assistance following rapid experimentation by many central banks during the global financial crisis.

“The overall message is that central banks need to prepare in calm times in order to be effective in providing liquidity assistance in times of stress,” said Hiroshi Nakaso, Bank of Japan deputy governor and the chair of the report working group.

The basic problem of liquidity assistance remains much the same as it always was: how to provide support to illiquid but solvent institutions, without creating excessive moral hazard. But the global nature of modern finance adds an extra dimension.

Central banks need firstly to prepare domestically, building co-operation with other authorities, to source market intelligence. Secondly, they need to build global links, for information-sharing, co-ordinated action in a crisis, and to tap into sources of foreign currency liquidity.

In a crisis, central banks need to have quick access to major foreign funding currencies, for example through a network of swap lines. One struggling institution may have exposures in multiple currencies, so saving it is likely to be a multilateral effort.

The document sets out eight principles for best practice among central banks. Besides urging central banks to build networks early, it offers advice on delineating the boundaries of illiquidity and insolvency, on collateral, foreign currency provision, how much transparency to offer, and provision of liquidity to markets, as well as individual institutions.

A key motivation for the CGFS is to develop the methods pursued during the financial crisis into a coherent framework that allows central banks to act in a predictable fashion, with as much transparency as possible.

Transparency may not be possible when saving an individual institution, due to the “stigma” attached to asking for help, but it is possible to set out the parameters guiding action beforehand. The report also suggests how central banks can make disclosures after an appropriate length of time has passed.

A relatively new area is the provision of liquidity to markets. For example, the Bank of England experimented during the crisis with acting as “market-maker of last resort” in sterling corporate funding markets.

The CGFS offers some suggestions for how such liquidity could be provided. One option is for a central bank to make “backstop bids” for securities – offering a price below that seen in normally functioning markets, but above the crisis level. A second option is to buy securities without pre-announcing the price using periodic auctions, but only doing so while the market remains dysfunctional.

The report also recommends central banks improve their knowledge of how markets operate, and share this knowledge with each other.