The fiscal and monetary authorities of the North Atlantic region have addressed the financial crisis/paralysis that has afflicted the region since August 2007 using a wide range of measures. Banks and other financial institutions have been nationalised or had minority state participations forced upon them. A wide range of bank liabilities, old and new, have been guaranteed. Central banks are actively performing the roles of lender of last resort and market maker of last resort. Both at the discount window and in repos, central banks now accept an increasingly wide range of collateral from an increasingly wide range of counterparties at an increasing range of maturities.
Still, the unsecured interbank markets remain paralysed. Volumes are minimal and spreads over the OIS rate (the market’s expectation of the average future official policy rate set by the central bank over the relevant maturity) remain at near-record levels. This matters if only because many loans to households and non-financial enterprises are priced off Libor, especially three months-Libor.
Addressing this anomaly is actually very simple, so one wonders why the central banks have danced around this problem for so long without taking the effective remedial action that is well within their authority and competency. All it requires is for the central banks to be willing to lose their virginity by engaging in unsecured interbank lending or, failing that, for the national Treasuries to stand up to their central banks by guaranteeing unsecured interbank lending.
There are two ways to eliminate the gap between the OIS rate and Libor.
(1) The central bank becomes the counterparty of last resort in the interbank market. Putting this another way, the central bank acts as a broker-dealer in the interbank market at all the relevant maturities. Operationally, this requires the following.
(a) The central bank selects the eligible participants in the interbank market. This need not be restricted to commercial banks.
(b) The relevant maturities at which the central bank is willing to lend unsecured (subject to individual borrowing bank limits) and willing to accept deposits without limit are (at the very least): overnight (this already happens on the deposit side), 1 week, 2 weeks, 3 weeks, 1 month, 2 months, 3 months, 6 months, 9 months and 12 months.
(b) The central bank lends to any eligible market participant, i, at a rate equal to the OIS (overnight indexed swap) rate at the relevant maturity, R, plus M > 0 plus X(i) ≥ 0. Here M is the minimum markup on the risk-free OIS rate charged by the central bank to any borrower, and X(i) is the further individual borrower-specific mark-up charged by the central bank to borrower i. Both M and X(i) would, of course, be functions of the maturity of the loan. The maximum amount lent by the central bank to any individual borrower would be some fraction of the borrower’s capital.
This lending is unsecured. Unsecured lending is an abomination to traditionally-minded central banks, even though the Fed has been cajoled buying commercial paper outright. But buying debt instruments outright probably does not feel quite as nakedly unsecured as lending unsecured to banks. Too bad. The central banks will have to go where no central bank has willingly gone before, and lend usecured to private banks. In mitigation, many of these ‘private banks’ are probably majority state-owned or at least minority state-owned by now. All of the central bank’s counterparities in the interbank market are de facto underwritten by the state.
(c) The central bank accepts deposits from any eligible counterparty in any amount at a rate given by the relevant OIS rate minus M.
If this is too complicated, the Treasury can address the interbank anomaly by guaranteeing interbank loans at all relevant maturities. The fee, per $, £ or € guaranteed for any given maturity, would be M + X(i). The Treasury could again impose a limit on the total volume of gross interbank loans extended to any individual institution. This should be too much of a stress for our new if-it-does-not-move,-guarantee-it Treasuries. After all, many national Treasuries now guarantee new medium and long-term unsecured bank deb, and some, like the Irish Treasury, guarantee all bank liabilities (possibly including interbank lending – I haven’t checked this).
Commercial banks would, I assume, prefer to have the central bank act as broker-dealer/interbank counterparty of last resort, because the banks know the central bank and may be less comfortable dealing directly with the Treasury. But if the central bank is acting coy about engaging in unsecured interbank lending, it either should be instructed to do so or face direct Treasury intervention in the interbank market through guarantees.
The margins M and X(i) should be set generously (that is, high) to encourage banks to bypass the central bank as broker-dealer and return to normal private interbank lending through private broker-dealers when financial markets normalise, but not so high as to discourage any and all interbank lending during financial crunch times. They should also be set high enough to offer the central bank (or the Treasury) a risk-adjusted rate of return on their intervention equal to the safe rate of interest at the relevant maturity. The purpose of the exercise is to repair a market anomaly, not to subsidise lending.
If the central bank were to engage in unsecured interbank lending, it ought to be indemnified automatically by the Treasury for any losses incurred as a result of this unsecured lending.
For this to work for unsecured interbank loans among banks domiciled in different national jurisdictions, there would have to be international agreement between central banks and/or national Treasuries. The agreement would specify which central bank provides the unsecured loan/which Treasury provides the guarantee, and from which party the guaratee is collected (the last point is a minor one, as the incidence of the guarantee should not depend on whether it is collected from the lender or the borrower, as long as the nationality of the provider of guarantee is the same).
These measures can be implemented forthwith. What are the authorities waiting for?