Financial Crisis and New Dimensions of Liquidity Risk: Rethinking Prudential Regulation and Supervision

Abstract

This paper aims to stress the importance of market liquidity for the stability of the financial system, emphasizing the pivotal role played by liquidity risk in the development of the current financial crisis, pointing out the flaws of regulation and supervision and stressing the need for their reform.

We first investigate the evolution of the concept of liquidity and the nexus between the transformations of financial systems and their increased vulnerability to liquidity risks. Then we focus on the causes of the emergence of liquidity risk in the ongoing financial crisis. We point out two intertwined processes: Firstly, the huge increase in financial assets stemming from the shift to an "originate-to-distribute" intermediation model; secondly, the growth of a parallel financial circuit. After this, we focus on the main lessons for regulation and supervision: first of all we address the case for adjustments to or reform of Basel 2 in view of the nexus between solvency and liquidity. Further crucial points relate to market liquidity and OTC markets, scale and scope of LLR function, architecture of supervisory authorities and perimeter of controls. Finally we stress the need for harmonization, or at least coordination, of national liquidity regimes, at least for cross-border groups.

Keywords: financial innovation, financial crisis, market liquidity risk, financial regulation, supervision

JEL Classification: D53, E58, F37, G1, G18, G21, G24, G28