Central bank whitepaper: Managing liquidity risk

A decline in market liquidity poses several challenges for central banks with ample reserves

Oct 20, 2017 | Arnab Das, Jennifer Johnson-Calari and Adam Kobor

Market liquidity can be defined as the capacity to transact in adequate quantities over short timeframes without materially affecting asset prices. A decline in market liquidity poses several challenges for central banks with ample reserves, heightening the importance of strategic asset allocation, dynamic rebalancing across liquidity and investment tranches and the effective management of liquidity risk.

In this paper we turn our attention to managing liquidity risk, examining the issue in the setting of a market environment characterized by innovation, changing regulation and – not least with quantitative easing reversing course – potentially tighter global liquidity.

Crucially, we argue that central banks’ management of liquidity risk, like their approach to strategic asset allocation, should not be rooted in a “set and forget” philosophy. Instead we advocate a framework based on defining eligible asset classes for discrete portfolio tranches and using alternative tools to “right-size” liquidity for potential intervention needs.

 

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