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that served so many so well for so long seemed somehow ill-suited to the evolving financial architecture.

Markets that rely less on securitizations, and are more transparent, have fared better in recent days and weeks. The stock market, while quite volatile, is about unchanged from mid- June levels. In the corporate bond market, spreads have widened somewhat, but current levels are close to historic averages, and issuance of investment-grade bonds has been quite sizable. Issuance of speculative-grade bonds has been sharply reduced, but aside from difficulties of LBO-related deals, this may reflect issuers' willingness to await improved conditions.

Not unlike prior episodes, it seems increasingly apparent that many investors and financial intermediaries became so content with the benign economic conditions and robust financial markets that they tended to act with confidence greater than warranted by the fundamentals. Indeed, some may have overly relied on credit ratings as sole gatekeepers for evaluating risks. So perhaps, in some sense, markets can become too liquid. In this case, markets may appear to function smoothly, but the risk-based pricing that lies at the heart of how financial markets efficiently allocate capital is impaired. The gloss of confidence may cause a misallocation of resources, and investors and financial intermediaries can be sidelined for a time, undermining the normal functioning of market operations.

Conclusion

Some months ago, I asked, "What happens when liquidity falters?"8 Highlighting the risks of a liquidity shock at some indeterminate point in the future is easier than ascertaining the consequences with precision. Reduced liquidity conditions in markets today stem from a pullback in investors' willingness to take risks, which may have been triggered, but I argue not caused, by losses in subprime-mortgage markets. Thus, a broader reassessment of risk positions appears at work, especially for products that are opaque or complex. Investors who had relied on credit ratings alone are now confronted with having to perform their own credit and market valuations. Some may now find they are not well-equipped to make these evaluations. How quickly markets normalize may depend on the speed with which investors and counterparties gain comfort in their abilities to value assets.

The adjustment process by private investors has increased the risk that banks may increasingly be called upon as backup providers of funding. The Federal Reserve responded to these developments by providing reserves to the banking system; it announced a cut in the discount rate of 50 basis points and adjustments to the Reserve Banks' usual discount window practices to facilitate the provision of term financing. In addition, earlier this week, the FOMC lowered its target for the federal funds rate by 50 basis points. The action was intended to help forestall some of the adverse effects on the broader economy that might arise from the disruptions in financial markets and to promote moderate growth over time. Recent developments in financial markets, including impaired price discovery, have increased the uncertainty surrounding the economic outlook. What originated as a liquidity shock could potentially give rise to increases in credit risk. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to meet our dual mandate, fostering price stability and economic growth.

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Warsh, "Financial Intermediation and Complete Markets."

BIS Review 104/2007

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