Session 2: The central bank’s role as a provider of liquidity

Franklin Allen, Imperial College London and University of Pennsylvania

Linda S Goldberg, Federal Reserve Bank of New York

One of the reasons why the financial crisis 2007-2009 was so severe was the acute liquidity shortage on the interbank market and other important markets.

From a theoretical perspective, it is not certain that central banks should provide the banks with liquidity under normal conditions, as the market can actually do so itself. But in crisis situations, the central banks have a very important role to play as providers of liquidity.

A complication here is that it is not clear what causes markets to cease being liquid, which is a problem for the central banks. Historically, apparently minor and insignificant events have led to significant global crisis and liquidity shortages.

Franklin Allen said that although academic research on liquidity is inadequate and it is not certain how central banks should tackle the real causes of liquidity problems, they should provide markets with liquidity in crisis situations. At the same time, this liquidity should not be unlimited.

Linda S Goldberg highlighted the fact that the central banks’ role as provider of liquidity to the financial markets in normal circumstances has become increasingly complex and larger in that financial institutions have grown and become increasingly complex in structure, at the same time as they operate on an increasingly global level. Moreover, the financial instruments used have become increasingly complicated.

She emphasised that meeting these challenges requires increased focus on the financial institutions’ own liquidity management, stress tests and oversight of these, which should reduce the central banks’ need to provide individual financial institutions with liquidity when they or the market experience liquidity problems.

Slides

"The Central Bank’s Role as a Provider of Liquidity" by Franklin Allen (Imperial College London)

"The Central Bank's Role as a Provider of Liquidity" by Linda S. Goldberg (Federal Reserve Bank of New York)