naked capitalism

Steve Cecchetti, Professor of Global Finance at Brandeis, has a nice post at Vox EU, “The Art of Crisis Management: Auctions and Swaps.” The title’s misleading; Cecchetti describes it as a FAQ on the central bank actions of last week to try to close the unusually high and troubling spread between interbank rates like Libor and risk-free rates, which indicates that banks aren’t willing to lend to each other.

The piece for the most part doesn’t, nor is it intended to, break new ground, but it’s a good synopsis for those who skipped over the details of the relevant stories last week. And it does have one important observation that we include below. Namely, the newly-created Term Auction Facility (which we view as a discount window with no stigma and another pricing mechanism) bears a strong resemblance to the ECB’s routine weekly auctions. And guess what. The gap between non-dollar Libor and the ECB’s target rate is higher than the spread between Libor and Fed funds. Not a good sign.

It also does a good job of describing some of the basics of Fed operations in lay terms (this is a good primer if you are in the unfortunate position of having to discuss Fed policy with, say, your mother, unless your mother happens to be a Treasury trader). Some excerpts:

Why are big private banks unwilling to lend to each other?

Clearly, they were worried about the quality of the assets on the balance sheets of the potential borrowers. My guess is that banks were having enough trouble figuring out the value of the things they owned, so they figure that other banks must be having the same problems. The result has been paralysis in inter-bank lending markets. Banks have not been able to fund themselves. And, as I will discuss in a moment, non-US banks faced an added problem – they could not get dollars. This was either because they could not get euros or pounds to then sell for dollars, or once they got their domestic currency they were unable to make the exchange….

In addition to permanent operations, the Desk injects funds into the banking system on a temporary basis using repurchase agreements.] They do this with a set of 20 qualified “primary dealers.” These are mostly large banks. In the current environment, the limited number of participants in the daily operations appears to have become a problem. I will explain why in a moment….

Why aren’t the traditional central bank policy levers working?

Everyone has described the current environment as a crisis. At the beginning of this column, I wrote that the patient was in intensive care – that sure sounds like a crisis. So, if banks can’t get funding from other banks, the theory is that they should go and get from the central bank by taking out a discount loan.

Well, they’re not doing it. The Federal Reserve reports that throughout October and November borrowing averaged around $300 billion a day. Not only that, but the Federal Reserve Bank of New York reports that in 3 out of every 10 days since the crisis started, the maximum trade in the federal funds market exceeded the discount lending rate.[6] That is, banks are willing to pay more to borrow from each other than they would have to pay to borrow from the Fed.

It’s not supposed to work this way. The discount lending rate is supposed to put a cap on the federal funds rate in the interbank market. The fact that it doesn’t is pretty damning of the classic theory of the lender of last resort. I suspect banks’ unwillingness to borrow from the central bank arises from the concern that it brands them as being un-creditworthy. You only borrow from the Fed if you no one else will lend to you – and that kind of signal makes it like that no one else will lend to you.

Bottom line

Putting all of this together brings us to the following fairly stark conclusion: Central banks have great tools for getting funds into the banking system; but they have no mechanism for distributing it to the places where it needs to go. The Fed can get liquidity to the primary dealers, but it has no way to ensure that those reserves are then lent out to the banks that need them. It is like a new-century version of the old ‘pushing on a string’ quip. Since the current crisis is about the breakdown of the distribution system, standard central bank instruments are simply not up to the task.

Interest rate cuts won’t ‘cut it’

It is important to emphasis that changes in the federal funds rate target will not fix the problem, so discussions that focus on the need for further target reductions are simply beside the point. Lowering the target overnight rate further would just mean providing additional reserves to the same primary dealers. Nothing makes me think that their failure to adequate distribute the funds they are receiving now would be addressed by simply giving them more.

Dollar shortage outside the US

Returning to something else I mentioned earlier, with the true globalization of the finance system, banking problems cannot be isolated by nation. This is an added problem. Not only do Central Banks need to ensure distribution of funds within a country’s banking system, they also need to make sure that cross-border distribution is adequate to meet the needs of banks in one country that require the currency of another. Today we have the new problem that dollars are in short supply outside of the United States….

Will it work?

I sure hope so. But there is one piece of evidence that makes me worried.

The TAF [Term Auction Facility] is very similar to the auctions that the ECB runs every week. With the exception of occasional daily operations, the entirety of the eurosystem’s reserves is injected through weekly auctions. All banks in the euro area can bid in these auctions, and the collateral accepted is quite broad. They are much more like the TAF than like the Fed’s normal temporary open market operations. If our diagnosis of the causes of the misbehavior of dollar LIBOR are correct and can be addressed by the TAF, then euro-LIBOR rates should look different. They do not.

Prior to the start of the crisis, the spread between one-month euro-LIBOR and the ECB’s target was roughly 10 basis points, as I write this, it is 93 basis points – that’s bigger than the dollar-LIBOR/federal funds rate spread of 74 basis points.