Banks and building societies ('banks') make long-term loans but fund themselves through on-demand or short-term deposits, so they are subject to liquidity risk: the risk that a material part of their funding is withdrawn before the assets can be realised at their true economic value.
Within certain bounds, liquidity risk is a standard feature of banking, and responsibility for managing normal day-to-day fluctuations falls to banks themselves, through a combination of holding some of their assets in liquid form, and seeking where possible to lengthen the maturity of their liabilities. But it is inefficient for banks to have to self-insure against extreme liquidity risks by holding excessively large stocks of safe liquid assets, or to have to undertake costly 'fire sales' of assets or sharp reductions in lending if such risks crystallise.
In such circumstances, central banks are well placed, as the monopoly suppliers of the most liquid means of payment — banknotes and central bank reserves — to act as backstop providers of liquidity to solvent banks: so-called 'liquidity insurance'.
In its liquidity insurance role, the Bank stands ready to provide solvent counterparties with highly liquid assets, in sufficient size and at an appropriate term, in exchange for a wide range of collateral assets of good credit quality but lower market liquidity. The terms of the Bank's liquidity insurance facilities are set to ensure counterparties have the incentive to manage their liquidity primarily through private markets in normal times.
Banks seeking to exchange less liquid for more liquid assets have access to three facilities, each with a different purpose:
- The regular monthly market-wide Indexed Long-Term Repo (ILTR) auctions are aimed at banks with a predictable need for liquid assets. The ILTR provides consistent six-month committed liquidity against the full range of eligible SMF collateral.
- The bilateral on-demand Discount Window Facility (DWF) is aimed at banks experiencing a firm-specific or market-wide shock. It allows participants to borrow highly liquid assets in return for less liquid collateral in potentially large size and for a variable term.
- The market-wide Contingent Term Repo Facility (CTRF) allows the Bank to provide liquidity against the widest collateral at any time, term and price it chooses, in response to actual or prospective exceptional market-wide stress.
The Bank also offers some liquidity insurance in the normal course of implementing monetary policy. Reserves averaging and OSFs are both designed to keep market interest rates in line with Bank Rate. But they both allow banks to absorb some liquidity shocks by varying their position at the Bank from day to day at little or no cost