MARkET AND FUNDING IllIQUIDITy: WhEN PRIVATE RISk BECOMES PUBlIC

The market turbulence that began in July 2007 stemmed initially from credit prospects deteriorating in U.S. subprime mortgages, but quickly spread to other markets. Growing uncertainty surrounding the valuation of structured credit instruments affected their liquidity, leading to difficulties in the asset-backed commercial paper (ABCP) market, where these instruments were partly funded. Illiquidity spread to the broader money markets as concerns grew over the extent of bank onand off-balance-sheet exposures to these instruments, requiring bank rescues and capital injections. The speed and extent of the transition from “market” illiquidity to “funding” illiquidity, and their subsequent interaction, was remarkable and required unprecedented intervention by mature market central banks to meet banks’ liquidity needs.1 As a result, important questions arise concerning the extent to which new financial instruments have increased the financial system’s vulnerability to liquidity events and the adequacy of the tools central banks have at their disposal to address such disruptions. The episode also has important implications for the clarity of central bank communications when balancing their responsibilities for formulating monetary policy and protecting financial stability. This chapter examines recent events and makes some recommendations for the future. The concepts of market and funding liquidity that are relevant for understanding the episode are examined first, along with how banks have managed liquidity risks in recent months. The