I came across this speech by David Longworth, Deputy Governor of the Bank of Canada which is very aptly titled as — Work in Progress: The Bank of Canada’s Response to the Financial Turbulence.
The speech is a very neat summary of what BoC has done over the last one year. Why did the liquidity problem arise:
Now, it is important to note that the decline in the liquidity of bank-funding markets and the decline in the liquidity of asset markets in general are not unrelated. Indeed, there are theoretical reasons to believe that market liquidity and the funding liquidity of banks with trading operations are mutually reinforcing, thus leading to the possibility of a “liquidity spiral” in a downward or upward direction.
This possibility arises because first, the ability of traders to provide market liquidity depends on the amount of funding they have and, second, the amount of funding they have, through capital and margin loans, depends on market liquidity. This second linkage arises because, with mark-to-market accounting, asset-price movements affect capital and because, empirically, margins tend to rise when asset prices fall.
On a different note, I would add that the leverage of trading operations is strongly procyclical, falling when asset prices fall and rising when they rise.
Excellent. Somehow BoC’s statments on liquidity are the best (see this as well). What did they do to resolve the crisis? This explains all their work in sum.
the central bank should be prepared, if necessary, to take steps that go beyond adjusting the aggregate supply of reserves, including providing an increased volume of term funds, conducting operations against a broad range of collateral, and conducting operations with a broad range of counterparties
However, after all the explanation of why crisis happened and how BoC supported the markets, Longworth says:
Two conclusions can be drawn from how these problems played out in Canada. First, the financial system is sound, and the Canadian financial, non-financial, and household sectors are strong enough to deal with the problems we have seen in financial markets.
Really? Then why was all that support needed? Could they have done better if the Central Bank had not intervened? He himself points to a report which says:
The CGFS report suggests that central bank actions in response to the market turbulence have been effective in that they have “reduced, though not resolved,” tensions in short-term money markets, thereby mitigating the damage to the economy.