The Role of Reserves in the Financial System: A New Approach to Market Safety

In today's global economy, where financial crises can trigger market freezes and economic disruptions, central bank reserves and public liquidity take on a new significance. This paper delves into how these resources can fill the liquidity gap during periods of stress in secondary markets. According to authors Frederic Boissay and Harald Uhlig, central bank reserves help financial intermediaries acquire assets during tough times but may crowd out investments. Under laissez-faire conditions, intermediaries often underestimate the importance of aggregate liquidity in mitigating market freeze risks. To address this paradox, a 'market-backstop principle' is proposed, inspired by Walter Bagehot's 'lender of last resort' concept. This approach suggests implementing conditional backstop interventions to restore market operations combined with modest liquidity requirements to limit moral hazard. The adoption of such an approach could potentially offer benefits in restoring market functionality that outweigh the fiscal costs of interventions.