The near collapse of the financial system that set off the global crisis was due in part to financial institutions suddenly lacking access to funding markets, and liquidity drying-up across securities markets. Financial institutions did not factor in how their own responses to a liquidity shortfall could make the entire system shut down. But, it only takes a few institutions to pull the plug on a liquidity-filled bathtub before it runs dry, and the central bank needs to open the spigots again. The key then is to make sure that firms have less incentive to pull the plug. To do that, in the latest Global Financial Stability Report, we have come up with a way to measure how much an individual financial institution contributes to system-wide liquidity risk.
It would be unfair for any assessment of global economic and financial stability not to acknowledge the tremendous progress has been made in repairing and strengthening the financial system since the onset of the global crisis. Still, the key message from the IMF’s October 2010 Global Financial Stability Report is clear. Progress toward global financial stability has suffered a setback over the past six months—the financial system remains the Achilles’ heel of the economic recovery. In this blog post, José Viñals discusses two broad issues. What is at the heart of this lingering lack of confidence? And, looking ahead, what are the policy priorities?