1 Liquidity By Charles Goodhart Financial Markets Group London School of Economics Some history: Sharp decline in liquidity ratios since 1960s. Why? 1.Failure of BCBS to agree a Liquidity Accord in 1980s. 2. Replacement of asset liquidity by funding liquidity:- (a) efficient market hypothesis (b) Basel II provides solvency assurance (c) in a crisis CB will always provide

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3 When crisis hits, (August 2007), CB unprepared for scale, extent and stigma problems. Moral hazard, vs. crisis resolution, (except ECB). Extension of liquidity assistance by maturity, collateral and financial counterparty. No possibility of enforcing ‘good behaviour’ by threat of failure. CBs provide liquidity insurance, so need to price insurance. CARs or specific premia?

4 How does one define liquidity risk against which CB provides insurance? General answer: maturity mismatch, but this does not depend on final maturity date of either assets (e.g. government debt) or liabilities (e.g. demand deposits). N.B. Asset liquidity depends, in part, on which assets CB will accept as collateral. Role of CGFS. Nevertheless assess maturity mismatch and impose a scale of sanctions on those with insufficient liquidity.

5 Mark-to-Funding The particular contribution of Geneva Report (A. Persaud). At the moment, accounting arrangements for banks depend on allocation to:- Hold to maturity Available for sale Trading book With complex, and now shifting, rules for migration between them. But if funding short-dated, any asset must be available for sale. If funding long-dated any asset can be held to maturity.

6 Rather than relate asset-accounting structure to initial purpose, which may be subject to change, relate it to funding structure, which at any time is known. But just how do you do this, since all liabilities fund all assets, indistinguishably. Allow banks to work out cost minimisation for themselves, so that long-dated liabilities applied to riskiest assets, short dated funding to less risky assets.

7 Varying views on ‘Mark to funding’. General principle of assessing liquidity risk, and applying sanctions for the riskier is, I believe, accepted. Problem of BCBS with sanctions, ultra vires.