Liquidity Production in Twenty-first-century Banking

This article examines how banks provide funding liquidity and market liquidity, and describes how these roles have evolved. Banks have a special advantage in managing funding liquidity risk but not market liquidity risk. Hence, many institutions provide market liquidity, while banks dominate in producing funding liquidity. Their comparative advantage stems from the structure of bank balance sheets as well as their access to government guarantees and central bank liquidity. This advantage became especially clear during the 2007–8 financial crisis, when the large stand-alone investment banks in the US all either failed, were purchased, or converted to bank holding companies. Liquidity production has always been, and continues to be, the core function of banking, but its form has changed in response to the development of financial technology and the deepening of securities markets.