Liquidity Risk, Credit Risk and the Federal Reserve’s Responses to the Crisis

26 Pages Posted: 15 Sep 2009

See all articles by Asani Sarkar

Asani Sarkar

Federal Reserve Bank of New York

Multiple version iconThere are 2 versions of this paper

Date Written: September 1, 2009

Abstract

In responding to the severity and broad scope of the financial crisis that began in 2007, the Federal Reserve has made aggressive use of both traditional monetary policy instruments and innovative tools in an effort to provide liquidity. In this paper, I examine the Fed’s actions in light of the underlying financial amplification mechanisms propagating the crisis — in particular, balance sheet constraints and counterparty credit risk. The empirical evidence supports the Fed’s views on the primacy of balance sheet constraints in the earlier stages of the crisis and the increased prominence of counterparty credit risk as the crisis evolved in 2008. I conclude that an understanding of the prevailing risk environment is necessary in order to evaluate when central bank programs are likely to be effective and under what conditions the programs might cease to be necessary.

Keywords: crisis response, Federal Reserve, counterparty credit risk, liquidity risk, limits to arbitrage

JEL Classification: G, G01, G1, G2

Suggested Citation

Sarkar, Asani, Liquidity Risk, Credit Risk and the Federal Reserve’s Responses to the Crisis (September 1, 2009). FRB of New York Staff Report No. 389, Available at SSRN: https://ssrn.com/abstract=1473133 or http://dx.doi.org/10.2139/ssrn.1473133

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