By Huw Jones
LONDON (Reuters) - The biggest tests for already weakened market liquidity may lie ahead amid "tectonic shifts" in money flow, though the Bank of England would intervene if volatility threatened financial stability, BoE Deputy Governor Minouche Shafik, said on Tuesday.
Shafik said bouts of extreme volatility in Chinese shares, U.S. Treasuries and Swiss franc raised concerns among central bankers that markets could be destabilised if selling became prolonged.
"But the biggest tests may lie ahead," BoE Deputy Governor, Minouche Shafik, said in a speech.
There were "tectonic shifts" taking place that may pose a challenge to how markets function, such as an end to low interest rates, money flowing out of emerging markets, and emerging market governments repatriating their money.
Volatility is being accentuated by weaker liquidity as market participants like banks have become less willing to smooth out heavy buying and selling.
Banks blame heavier capital requirements on the inventory of bonds and shares they would need to hold to offer prices to investors, even in turbulent periods.
So far the "taper tantrums" and episodes of rollercoaster trading have been largely confined to a single trading day, but Shafik said a prolonged bout could spark a broader rush for the exit and undermine confidence in markets and their ability to raise funds for the economy.
Tougher regulation was "part of the story", she said, but other factors also feature, such as a better appreciation of risk in markets. Banks and others were also running trading inventories more efficiently, akin to manufacturers who hold "just in time" stocks for their production lines.
It was the second speech by a BoE deputy governor on market liquidity in as many weeks, highlighting a topic that is challenging U.S. and global regulators as well.
The BoE is due to publish a staff paper on market liquidity later this week.
Shafik said that ultimately much of the responsibility for adapting to changes in market structure lies with banks and others who must price liquidity properly.
She sought to reassure investors, saying the BoE can help in three ways, such as by giving clarity on the course of interest rates from record low levels.
"Monetary policy makers in the US and UK will likely consider it appropriate to gradually tighten monetary policy should the recovery in their respective economies continue," she said.
The Bank had also acted as a "market maker of last resort" during the 2007-09 financial crisis and could do so again within limits, she said.
"Were liquidity to deteriorate again to such an extent that it was judged to pose a systemic threat to financial stability or the transmission of monetary policy, the Bank would stand ready to act as a market maker of last resort again," Shafik said.
The BoE will also hold an Open Forum next month when the cumulative impact of new regulation will be discussed, she said.