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Global liquidity: a view from Basel

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Jaime Caruana

General Manager, Bank for International Settlements

International Capital Markets Association Annual General Meeting and Annual Conference

Paris, 26 May 2011

I appreciate the opportunity to address this important grouping of capital market professionals.

Today, I would like to take up the issue of global liquidity. The recent financial turbulence has highlighted the crucial role of liquidity in global markets. Global liquidity is being discussed in the G20, in part because policymakers in emerging markets are concerned that monetary developments in the main economies are stimulating capital flows. Yet the discussion lacks focus, in part because of the many meanings that are attached to the term "liquidity" in general and "global liquidity" in particular.

In my remarks this afternoon, I shall make five points, which will address different but related aspects of the debate about global liquidity:

First, your role as credit originators makes you a key source of global liquidity.

Second, as a case in point, I will highlight the contrast between shrinking dollar credit to private borrowers in the United States and expanding dollar credit to borrowers elsewhere, all with a single policy rate determined by the monetary authorities.

Third, international credit tends to amplify domestic credit booms, posing first-order policy challenges.

Fourth, during the run-up to the global financial crisis banks’ maturity mismatches made financing within and between currencies very easy, but made banks vulnerable to rollover risk.

Fifth, macroprudential policy and Basel III provide key mechanisms to stabilise your provision of liquidity.

Let me take each point sequentially.

International credit markets: today’s gold mines

But first, what is meant by global liquidity? And what generates liquidity?

Liquidity is a broad term with many uses. It has specific definitions in terms of quantities and prices, markets and securities. An underlying common element, however, is the "ease of financing", ie the readiness with which an expected cash flow, claim or a liability can be turned into cash. For present purposes, by "liquidity" I will mean the extension of credit, and by "global liquidity", the extension of credit globally, with particular reference to the role of market participants.

Regarding what creates global liquidity, my answer is simple and adapted to the present global economy. But first let me cast doubt on a venerable, but in my view incomplete, answer.

The answer is not central bank liabilities per se. We learned in school how central banks create base money, sometimes known as "high-powered money".

In turn, this is supposed to lead to an expansion in credit and money (the "money multiplier"). In fact, even in normal times there is no such causal, mechanistic relationship. Central banks meet the demand for central bank liabilities passively at their chosen policy rate. And there is no stable link between this and credit expansion, across place or time. In fact, where reserves are not even required, the monetary base consists almost entirely of notes and coins with the public – hardly a solid foundation for credit expansion! The absence of a stable mechanistic relationship becomes most apparent in bad times, when balance sheets need repair. We should have learned from Japan 10 years ago that central bank reserves can, in fact, have very low power. Similarly, the expansion of bank reserves in the United States in the last few years has not been associated with a parallel expansion of broad money or bank lending in the United States (Graph 1).

Part of the correct answer is the policy interest rate set by central banks. This influences the price of leverage in a given currency. But this influence has its limits too that become most apparent when interest rates are close to zero and balance sheets need repair. The recent experience in the United States and that in Japan 10 years ago confirm this.

A bigger part of the right answer is private market participants’ actions. It is you, private market participants, who play a key role. It is the waxing and waning of your perceptions and attitudes towards risk, valuations and cash flows that drives credit extension. This is true within a particular jurisdiction as well as internationally. International credit markets, including bank and securities credit, give rise to international credit, just as domestic banks and securities markets give rise to domestic credit. Together these make up global credit.

You, meaning investors, issuers and underwriters, and bankers, are the gold mines of today. The upside of this substitution of credit for gold was well captured by Daniel Webster:

Credit – man’s trust in man – has done a thousand times more to enrich mankind than all the goldmines in the world. It has exalted labour, stimulated manufacture and pushed commerce over every sea.

But there is a downside, too. Overabundance of credit tends to generate its subsequent scarcity. We have witnessed this recently. In the run-up to the crisis, underwriting standards deteriorated and leverage increased. When intermediaries’ trust in intermediaries vanished, only the interposition of central banks’ balance sheets kept credit from contracting in a vicious manner. In the end, only healthy intermediaries and properly functioning private credit markets can restore an appropriate flow of credit.

Read the rest of the report here: http://www.bis.org/speeches/sp110526.pdf

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