An inherent feature of a commercial bank's business is "maturity transformation". Customer deposits may be available for instant withdrawal and bank lending may be committed for years. So banks run liquidity risks. Even a well-run bank could suffer an unexpected shortage of liquidity. And, if depositors fear there are not enough liquid assets to be able to meet deposit withdrawals, a "run on a bank" could ensue.
The Bank, as the supplier of central bank money, is able to be a back-stop provider of liquidity, and therefore provides liquidity insurance to individual, credit worthy institutions and to the system as a whole.
The Bank's liquidity insurance must be provided in a way that takes account of the potential for "moral hazard" - the incentive for individual banks to undertake riskier actvities because of the presence of a central bank back-stop. The Bank's operations are designed to provide liquidity support on appropriate terms to encourage banks to manage their liquidity needs safely in the market rather than turn to the Bank routinely.
In the first instance, banks can vary their reserves account balances to reflect changes in their day to day liquidity requirements. They can also draw on the Bank's Operational Standing Facilities - these allow banks overnight access to central bank money to manage unexpected 'frictional' payment shocks that could otherwise cause them to go overdrawn or to fail on other transactions.
In the face of wider financial turbulence, the Bank's framework for liquidity insurance operates through its regular Indexed Long-Term Repos (ILTR) and its bilateral Discount Window Facility (DWF). The Bank can also activate its Extended Collateral Term Repo (ECTR) Facility in response to actual or prospective market-wide stress of an exceptional nature.
The ILTR is an auction-based operation where banks can borrow from the Bank against a wider range of collateral. The DWF operates by offering to swap, for a fee, a bank's high quality, but illiquid assets for liquid UK government bonds or, in exceptional circumstances, for cash. The ECTR Facility enables the Bank to undertake operations against a much wider range of collateral than is eligible in the indexed long-term operations.
The Bank's approach to Liquidity Insurance is set out in more detail in the Red Book: