The author argues for the establishment of more predefined, permanent, market-wide emergency liquidity mechanisms.
February 9, 2016 – The Bank of Canada should start preparing for the next financial crisis, according to a new C.D. Howe Institute report. In “Looking for Liquidity: Banking and Emergency Liquidity Facilities,” author Jeremy Kronick urges the Bank (BoC) to establish new permanent liquidity pools that would be instantly available in times of crisis.
Financial institutions face a smaller liquidity market today than prior to the 2008-09 crisis. As a result, when the next financial crisis hits, these institutions could face increased difficulty obtaining funding from private markets. For example, in the United States, daily trading volumes of agency mortgage-backed securities fell from US$321 billion in 2010 to US$178 billion in 2014.
“The 2008-09 global economic crisis showed us that liquidity is king,” commented Kronick. “The BoC was right to step in and provide emergency funding to fend off a system-wide breakdown. However, similar to the Bank of England, I urge the BoC to go one step farther and make market-wide, long-term liquidity facilities permanent.”
The author argues for the establishment of more predefined, permanent, market-wide emergency liquidity mechanisms. These permanent mechanisms would allow for on-going design improvements as market conditions evolve, adding transparency for market participants.
Furthermore, while the design of the emergency liquidity mechanisms introduced by the BoC during the 2008-09 crisis was appropriate, the auction format used likely fell short of generating the competitive prices and quantities that create both optimal liquidity distribution and the highest possible return for the public. Therefore, the author stresses the importance of getting the design of permanent mechanisms right. He recommends the use of the “Product-Mix” auction design, which involves an unlimited bid, single-round process in which bids are made on different forms of collateral simultaneously, and no minimum reference price above the benchmark overnight rate is established in advance.
Kronick concluded: “Not only was access to liquidity crucial in 2008-09, but so was speed. More emergency liquidity facilities that are permanent ensure the Bank’s ability to stabilize a shock quickly.”
Click here for the full report.
The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.
For more information contact: Jeremy Kronick, Senior Policy Analyst, C.D. Howe Institute: 416-865-1904 or email: kmurphy@cdhowe.org.