Research Discussion Paper – RDP 2008-06 Promoting Liquidity: Why and How?
October 2008
Abstract
As recent experience all too clearly demonstrates, liquid markets do not exist for all financial assets at all times. In some respects, this can be thought of as a market failure. This paper addresses how best to promote asset market liquidity given this market failure, and the appropriate balance between the private and public sectors in establishing arrangements for dealing with liquidity problems. There are three main conclusions. First, improvements in the financial infrastructure – including arrangements for disclosure and post-trade processing – have a role to play in limiting the sharp rise in information asymmetries that can occur when conditions in financial markets are strained and at turning points in the financial cycle. Second, recent events have shown up shortcomings in the way that financial institutions manage their own liquidity, and these shortcomings need addressing. Third, it may be welfare-improving for the public sector to provide liquidity services when liquidity is strained. The central bank can smooth liquidity over the cycle, and the public sector can facilitate the change of ownership of assets from a troubled institution, which in extremis may include the public sector buying assets outright. If the public sector does actively provide liquidity services, then arrangements need to be put in place to ensure that the potential welfare gains from doing so are not undermined by financial institutions taking on greater risk than is warranted.