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Turner examines the principles underlying central bank liquidity actions taken during the financial crisis. The toolkit of central banks has expanded dramatically. A bigger toolkit seems always better, provided those using its potentially dangerous tools are fully cognizant of the attendant risks. Only central banks can provide the assurances of liquidity often needed in a financial crisis. In the extreme conditions prevailing in autumn 2008, it was natural that fighting the crisis received priority. Before this crisis, nobody expected the scale of operations central banks would be drawn into—and many of these operations will at some point have to be unwound. A lot of these measures, however, will probably be permanent. Turner suggests three areas where the changes decided on during this crisis are likely to endure: increased term financing, wider deposit arrangements at the central bank, and better cross border provision of liquidity.

This chapter discusses the basic analytical framework of “second-generation” models of currency crises and their extensions to deal with new characteristics of international financial crises such as the connections between financial fragility and currency instability, government's reputation and credibility, asymmetric information and herding behavior, contagion across markets and countries, financial intermediation and liquidity crises, credit constraints and balance-sheet effects, strategic interaction among agents and equilibrium selection. The most important implication to emerge from this approach is that the run on central bank foreign reserves does not require policy inconsistencies and an adverse trend in the fundamentals before the crisis. The attack itself may induce an optimizing regime-switching choice that makes the crisis self-validating. Thus, the exact timing of a speculative attack turns to be indeterminate and arduous to forecast.

This chapter discusses the effects of the First World War on the City, reviewing opportunities for much greater dealings in foreign exchange and the ‘bill on London's rapid revival’. The war not only resulted in sterling becoming a floating currency but also caused the London capital market to be regulated, which is analysed in this chapter. The chapter then focuses upon how the 1931 liquidity crisis severely affected the City through leading houses' substantial commitments to Central and Eastern Europe. It also reviews the City's ‘long winter’ caused by, first, the world economy's prostrate state, and then the Second World War. In addition, the discussion in this chapter focuses on the recovery of the City's international role during the 1950s and the beginnings of an entirely new foundation for its global importance with the emergence of the Euromarkets. Some reflections on the City's experience during the first half of the 20th century are offered at the end of the chapter.

Articulates the basics of global games. Applies the global game arguments of Morris and Shin (1998, 2000) to sovereign liquidity crises and shows how the fundamental and sunspot views of crisis can be reconciled. Highlights the welfare costs of coordination failure and explores how policy options such as sovereign debt standstills, liquidity management, and capital controls may help mitigate these costs.

This chapter develops a model of interbank lending in which unsecured claims, repo market activity, and shocks to haircuts applied to collateral assume centre-stage. Systemic liquidity crises of the kind witnessed during 2007–8 are shown to arise in such a framework. The model illustrates how the complexity and concentration of a financial network can act to amplify its knife-edge properties. It also discusses how a range of policy measures, including tougher liquidity regulation and surcharges for systemically important financial institutions (SIFIs) could make the financial system more resilient.

A financial crisis is normally associated with a liquidity crisis, which has typically a funding and a market dimension. This chapter introduces the mechanics and amplifiers of financial crises with simple illustrative models, and explains the role of the central bank from the financial stability and monetary policy perspectives. The role of asset value shocks, adverse selection, market liquidity, bank runs, and the leverage cycle for the funding liquidity of banks and the funding costs of the real economy is explained. The central bank, as only agent in the economy which is not subject to liquidity constraints, plays a key role in preventing liquidity crises from escalating and leading to widespread defaults, and in avoiding related deflationary dynamics.

This chapter examines whether an international lender of last resort (ILOLR) would be a useful addition to the international financial architecture. It analyzes whether an ILOLR can function effectively as a fund with limited and predetermined resources using a model of an emerging economy vulnerable to international liquidity crises. The findings reveal that required size of the ILOLR depends on how its resources are used by the domestic authorities. This chapter explains that if the LOLR backs a guarantee of the foreign currency liabilities of domestic banks, its resources do not need to be larger than the liquidity gap in the domestic banking sector.

This chapter analyzes small, open economies with important financial markets. The two countries of this type analysed here are Ireland and Denmark. These two countries did not struggle with exactly the same challenges. While Denmark had to avoid a currency crash, Ireland's policy autonomy was severely constrained through the European institutions. In both cases, the financial sector invested heavily in the domestic housing market, relying excessively on international wholesale funding for short-term liquidity. Consequently, the housing market bubble burst and financial institutions found themselves unable to access these previously available international markets. The governments responded, almost simultaneously, by issuing a guarantee on deposits and bank debt to reassure markets. With time, however, the liquidity crisis revealed severe solvency problems in several important banks, so that recapitalization and other measures became necessary.

Explains how policymakers must trade the ex-post costs of creditor coordination failure, which can help discipline sovereign debtors, against the ex-ante costs of debtor moral hazard. The threat of a liquidity crisis—a creditor run—is shown to be a powerful, albeit blunt, disciplining force in international capital markets, and the chapter explores the circumstances under which official intervention by the IMF can substitute for this discipline. The efficacy of collective action clauses as a means of ameliorating creditor coordination problems is also given a formal treatment.

The recent central banking literature often argues that the LOLR function would be the key feature defining a ‘modern’ central bank. This chapter argues that this view may appear too radical (despite the enormous benefits of the LOLR) as the appearance of the LOLR does not change the nature of central banking (which is primarily associated with the issuance of central bank money). After providing an overview of the roles of central banks for financial stability, the chapter focuses on one early LOLR episode, namely the measures of the Hamburger Bank, Bank of Amsterdam and Bank of England in the European debt crisis of 1763. It is shown that in particular the Hamburger Bank acted as systemic lender of last resort, comparable to what modern central banks did in 2008.

This chapter considers the phenomenon of financial globalization. This type of globalization is organized within the role of financial intermediaries, especially banks, in the proliferation of financial cycles. Firstly, this chapter reviews the merits of financial globalization with particular attention to the effects of unhindered capital flows. Secondly, it analyzes these effects against the financial system as a whole of the balance sheet management done by the financial intermediaries, after which the next section applies these insights to four certain episodes; namely, the 2008 liquidity crisis in Korea, Japans experience in the 1980s, US financial crisis of 2007–2009, and the European crisis that began in 2010. The chapter concludes with an emphasis on the importance of macro-prudential policies.

After taking into account biases induced by infrequent trading and selection, it is unlikely that illiquid asset classes have higher risk-adjusted returns than traditional liquid stock and bond markets. However, there are significant illiquidity premiums within asset classes. Portfolio choice models incorporating illiquidity risk recommend that investors should retain only modest holdings of illiquid assets and demand high risk premiums for investing in them.

This chapter argues that the conventional approach to the management and resolution of external financial crises in emerging economies is inefficient and inequitable and needs to be reformed. Such reforms need to account for increased complexities arising from deepened integration, notably the difficulties in differentiating between external and domestic debt in terms of their holders, currency denomination, and governing laws. Effective debt resolution mechanisms would be needed to bail-in creditors whether the crisis is one of liquidity or solvency, or due to private or sovereign debt, or locally or internationally issued external debt, particularly since crises caused by excessive private borrowing lead to large increases in public debt. Debt workouts should include temporary standstills, protection against creditor litigation, lending into arrears and debt restructuring and combine statutory and voluntary elements, including collective action clauses, duly reformed to avoid the kind of predicaments encountered during the Argentinian restructuring.

This chapter discusses the history of debt crises, such as the Latin American debt crisis of the 1980s and Mexico’s Tequila Crisis of the mid-1990s, as well as the recent EU crisis. It lays out a model of sovereign borrowing, debt pricing and default to analyse these crises.