On Wednesday, 12th December 2007, five central banks, the Fed, the ECB, the Bank of England, the Bank of Canada and the Swiss National Bank (SNB) were reported to have launched a coordinated attack on the North Atlantic liquidity crisis that has been with us since August 2007. In a contribution to the Financial Times’ Economists’ Forum, I have argued that in fact there was no announcement of any policy action that required substantive policy coordination. Instead we had the simultaneous and joint announcement of a set of five disjoint policy packages, one for each of the central banks severally, none requiring the coordination of the actions of more than one central bank.
What did the individual central banks announce?
Ignoring the coordination spin the Famous Five tried to put on their disparate and substantially independent policy actions, what can one say of the substantive measures taken by the three largest of the five individual central banks involved in the joint announcement?
The Bank of England
To the Bank of England’s credit, it was not part of the attempt to present the shadow-boxing currency swap-cum-US dollar repo package as the real Merriweather-Hatton thing. Indeed, the most important change in liquidity policy and the largest intervention (in relation to the size of the underlying economy) was announced by the Bank of England. It increased the scale of two already announced long-term open market operations (OMOs) through repos on 18 December and 15 January by £8.5 bn to £11.35bn. Of this, £10bn would be at the 3-month maturity where most of the pain has been, and which is important as a key benchmark for the pricing of bank credit to household and non-financial corporations.
More importantly, the repos at the 3-month maturity will have a much wider range of acceptable collateral, and they will not be subject to a penalty rate or a penalty floor to the rate. This is in contrast to when the Bank of England on September 19 announced four term auctions for which the minimum bid rate was 100 basis points above Bank Rate. Because of this, and possibly also because of stigma attached to participation in these special term repos, there were no takers for the Bank’s offerings. More US dollar-denominated securities will be accepted as collateral in the December and January auctions, including debt issued by the US Government Sponsored Entities (GSEs), Fannie Mae and Freddie Mac. The most important addition to the list of eligible collateral, however, are AAA-rated tranches of UK, US and EEA asset-backed securities (ABS) backed by credit cards; and AAA-rated tranches of UK and EEA prime residential mortgage-backed securities (RMBS) and covered bonds rated AAA.
This modification in its collateral procedures brings to Bank of England much closer to fulfilling the role of market maker of last resort (MMLR) advocated by Anne Sibert and myself. It did not increase the range of eligible counterparties in the repos, so one has to hope that the additional liquidity will make its way through the OMO-eligible counterparties to financial institutions that need it but are not on the OMO-eligible list.
Even with this relaxation of its collateral requirements for 3-month repos, the Bank of England has a more restricted list of eligible collateral than the ECB, which accepts similar classes of assets but only requires an A rating. The Bank has not relaxed its collateral eligibility requirements for repos at maturities other than three months or at its discount window (the standing (collateralised) lending facility, which makes overnight loans at a rate 100bps above Bank Rate). The Bank is learning, but slowly….
The next most important announcement came from the Fed. It established a temporary Term Auction Facility (TAF), to auction loans to the counterparties and against the collateral normally acceptable at its primary discount window. Both the list of eligible counterparties and the set of eligible collateral at the primary discount window are wider than for conventional repos through OMOs. Two auctions have been scheduled thus far, for December 17 and December 20, for USD20bn each.
While eligible collateral and eligible counterparties are the same for the TAF as for the primary discount window, there are important differences. First, the primary discount window is at a penalty rate of 50 basis points over the Federal Funds target rate for overnight loans. The TAF rates will be determined through the auction, subject to a floor set by the OIS rate (the overnight indexed swap rate), which measures the market’s expectation of the compounded overnight Federal Funds rate over the term of the loan.
Second, the standard term of the primary discount window is overnight. This was, in August, extended to loans with up to a one-month duration. The proposed auctions are for 27 days and 35 days respectively. Rather surprisingly, the Fed appears to be focusing more on possible year-end kerfuffles, which I consider to be of the millennium bug variety, i.e. not systemically important, than on the 3month Libor spread anomaly, which will be with us long after the bridge to the new year has been crossed safely.
Third, access to the primary discount window is demand-determined (subject to the would-be borrower having the right collateral), while with the TAF, the Fed comes to the would-be borrowers. With many borrowers in the TAF auctions, the stigma attached to borrowing at the primary discount window should be avoided.
Fourth, borrowing at the primary discount window has typically been in small amounts. The two auctions scheduled thus far are also for small amounts (up to USD20bn each, with a limit of 10 percent of the auction for any one borrower), but these numbers could be raised even for the December 27 auction, and certainly for any future auctions that may be scheduled if the temporary TAF were to become a permanent feature of the Fed’s liquidity management toolkit.
The only substantive new measures announced by the ECB were two more term repo operations against its usual collateral, on the same dates at the Fed repos (December 20 and 27) and for the same small amounts (USD20bn on each of the two dates). For an organization that has pumped as much as €100bn into the markets in a single auction, this is small potatoes. There was no relaxation of its collateral requirements, nor any increase in the list of eligible counterparties. As argued earlier, the fact that the ECB (and the SNB) will do repos in US dollars rather than in euros is worth a yawn at best. It looks like the substitution of motion for action.
The markets, for once, saw immediately who had made a substantive policy move and who had not. Following the joint announcement, 3-month sterling Libor dropped by 10 basis points; 3-month USD Libor by 6 basis points and 3-month Euribor by nothing. That’s about right.
The response of the interbank spreads and rate levels to the policy announcement makes clear the magnitude of the task remaining, because the 3-month interbank spreads over the OIS rate remain around 100 basis points. The monetary authorities of the five countries involved in the announcement will have to do more, both as regards the scale of the repos and, in the case of the UK at least, as regards the collateral that will be accepted. There is no risk of contributing to moral hazard, that is, rewarding past reckless lending or borrowing behaviour by banks and other financial intermediaries, as long as the collateral offered in the repos is valued properly and subject to appropriate haircuts.
But the central banks cannot do it alone. Today’s Financial Ttimes reports that the Eurozone’s 21 largest banks hold €244bn in off-balance sheet assets that may have to be brought back on their balance sheets. This could trigger a credit squeeze in the wider economy, as these banks hoard liquidity in preparation for the ‘Great Balance Sheet Take-In’. Clearly, the central banks can and should provide the additional liquidity (properly collateralized and priced) needed to facilitate this re-intermediation of prior off-balance sheet exposure.
However, the demand for liquidity is not just driven by the need to take a given known value of off-balance sheet assets onto the banks’ balance sheets. It is also driven by pervasive uncertainty about who owns what and who owes what and to whom. Massive losses have been incurred on a wide range of asset-backed securities (not only subprime mortgage-backed (RMBS)) that have not yet been recognised by the owners of these assets, revealed and reflected in balance sheets and profit and loss accounts. Hundreds of billions of US dollars worth of capital losses are still ‘missing in action’.
With the mood of the markets having turned from euphoria to depression, subjective perceptions of pervasive counterparty risk are paralyzing lending. A solvent and liquid potential lender will not lend at 3-month maturity to a counterparty if there is material uncertainty in his mind about the solvency of the counterparty or if the potential lender fears that both he and the counterparty may be illiquid three months from now. The failure of too many banks to come clean about their losses is acting like a prohibitive tax on new lending.
When banks recognise and reveal their losses, the first cause of unwillingness to lend (high subjective perceptions of default risk by the would-be borrower) would disappear. But the second cause of illiquidity today (fear of lender and borrower illiquidity 3 months from now) remains and can only be efficiently tackled by the central banks. It is not enough for central banks to insist that three months from now they will stand ready to inject overnight liquidity. Seeing is believing. Term liquidity today beats overnight liquidity tomorrow.
Liquidity is a public good. It can be managed privately (by hoarding inherently liquid assets), but it would be socially inefficient for private banks and other financial institutions to hold liquid assets on their balance sheets in amounts sufficient to tide them over when markets become disorderly. They are meant to intermediate short maturity liabilities into long maturity assets and (normally) liquid liabilities into illiquid assets. Since central banks can create unquestioned liquidity at the drop of a hat, in any amount and at zero cost, they should be the liquidity providers of last resort, both as lender of last resort and as market maker of last resort. There is no moral hazards as long as central banks provide the liquidity against properly priced collateral, which is in addition subject to the usual ‘liquidity haircuts’ on this fair valuation. The private provision of the public good of emergency liquidity is wasteful. It’s as simple as that.