Grading Central Bank Performance in the Credit Crisis

The Financial Times has an interesting piece today by Chris Giles and Gillian Tett, “Lessons of the credit crunch.” The world’s top central bankers have learned that their traditional policy tools haven’t worked as well as they would have liked.

So how to judge the job they have done? The FT story fails to address the dead body in the room – to what degree are they culpable for the mess by virtue of overly generous policy rates and lax oversight. It instead focuses on a narrower question: how well have they coped with the mess that began last August?

Note that the article does not offer the authors’ opinion; instead it presents how the monetary authorities themselves view their performance to date. Several worrying themes emerge.

The first is an unwillingness to admit how out of their depth they are. The article hints at it in the set-up paragraphs; Timothy Geithner, the president of the New York Fed, unwittingly admitted in a speech a year ago how limited the Fed’s oversight was and how incomplete their understanding of the new instruments is. In the past, the Fed often had former financiers or bankers among its top ranks. Now that the markets and products have increased dramatically in complexity, it has even less real-world expertise than in the past.

The second is more than a bit of self delusion. The Fed, for instance,

is proud of maintaining a methodical approach, reflecting a belief that as the world’s most important central bank it should not surprise the markets at a time of instability and risk.

An emergency 75 basis point rate cut, which it turns out was largely in response to signals sent by SocGen unwinding Jerome Kerviel’s trades, is methodical? If they can convince themselves that panicked = methodical, they are sorely out of touch with reality. And unfortunately, as many have lamented, “not surprise the markets” appears to be code for “shore up asset values.” As Willem Buiter has tartly observed,

It was the excessive response of the Fed to earlier stock market collapses that, together with global regulatory failures, created the credit boom and bubble that brought us the August 2007 credit crunch and the January 2008 stock market collapse. A repetition of that error of judgement, especially on a global scale, would in due course bring us a financial crisis that would dwarf the one we are trying to escape from now. It is time for central bankers everywhere to put their fingers in their ears and show some backbone. Their mandates are clear (perhaps less so in the US, with its confusing triple mandate, but even there, long-term financial stability considerations argue against giving the junkie his fix). Rates will have to be lower than they would have been based on the information available as of January 20. But the markets are the tail, not the dog in this story.

Third is that the monetary authorities pulled out all stops in December to lower the gap between interbank lending rates and the Fed funds rate which had risen to levels that said banks weren’t lending to each other. One remedy, the Fed’s Term Auction Facility, which was intended to be temporary, appears to have become permanent. What happens if spreads rise to troubling levels again? Satyajit Das reports they are moving in that direction:

Will Rogers once remarked that: “You can’t say that civilization don’t advance; for in every war they kill you a new way”. In the current credit crunch, the behaviour of inter-bank rates is proving deadly to a new generation of traders.

The difference between inter-bank rates (LIBOR or the London Inter-bank Offered Rate or it equivalent in other currencies) and central bank rates or government bond rates has increased sharply. This is making inter-bank and corporate borrowings expensive contributing to problems in the credit markets.

This difference is the “swap spread” also known as the Treasury Eurodollar (“TED”) spread – the margin between inter-bank rates and government bond rates of the same maturity.

Swap/ TED spreads are up 30/40 basis points per annum to around 60/70 bps. During the 1998 Russian/ LTCM episode swap spreads peaked at well North of 100 basis points per annum.

We’ll probably muddle through somehow if we have another evaporation of liquidity, simply because the central bankers will keep at it until they find something that works.

Fourth is that the discussion is focused so narrowly on banks and money market operations. There appears to be no consideration of possible sources of systemic risks (say counterparty defaults that lead the credit default swaps market to seize up, or worse, generate large writeoffs) even though those wind up in the laps of the banking authorities. The central bankers seem to be reactive rather than pro-active.

This article is long but worth your attention. From the Financial Times:

Six months ago this week, the world realised the credit party was over. Ever since, the spotlight has been shining on the very core of central banks’ operations – the process of setting interest rates in markets and their skill in easing the first generalised transatlantic liquidity shortage for decades.

None of the institutions at the heart of the crisis – the Federal Reserve, the European Central Bank and the Bank of England – has found the past half year comfortable. The period has been the equivalent of a test-tube experiment in modern central banking, and policymakers now resemble a distinctly uneasy group of scientists: they know what policies they have put into the pot in recent months, but are far from clear why the markets have reacted in certain ways – and even less sure that they have devised the perfect cocktail to stop markets erupting again…

This behind-the-scenes debate has already identified four big problems that have emerged in the US, the eurozone, the UK and other advanced economies, with the possible exception of Japan.

First, all the central banks have found it very hard to keep short-term market interest rates where they desired in recent months – which has caused alarm, since these short-term rates are a key plank of modern monetary policy.

Second, the banks have also found it difficult to use the standard tools at their disposal to direct liquidity to troubled parts of the financial system. This partly stems from a third crucial problem: private-sector banks have become so concerned about the issue of “stigma” that they have sometimes refused to take cash from the central bank – even when they needed it.

Fourth, all the major central banks are now beset by the issue of “moral hazard” – the concern that their actions in offsetting market turmoil might prompt investors to take even bigger risks in future, with potentially catastrophic consequences.

Each of the central banks believes it has addressed at least some of these four challenges relatively well. The US Federal Reserve, for example, is proud of maintaining a methodical approach, reflecting a belief that as the world’s most important central bank it should not surprise the markets at a time of instability and risk.

The European Central Bank, for its part, believes it acted decisively at the start of the crisis – and then adopted a more flexible stance that enabled it to calm the three-month money market relatively well.

Meanwhile, the Bank of England boasts that it is the only central bank to have significantly raised the total amount of central bank liquidity on offer, by 37 per cent between August and the end of last year – a stance somewhat at odds with its reputation for having been a central bank scrooge.

But even if the three central banks can each point to some successes, none has emerged from the past six months with a stunning track record – let alone any sense that its policies have unfolded as expected. Each has essentially been muddling along using the imperfect tools at its disposal, plagued by a sense that it does not entirely understand exactly why some policies work better than others.

In the US, for example, the past six months have shown that the Fed is in some ways hampered by money-market tools that have been found deficient. In normal times, the Fed deals in overnight markets with only about 20 counterparties, known as the “primary dealers”, who distribute liquidity at close to the Federal Funds rate to the rest of the banking system and to longer-duration markets. In central banking terms this system is decidedly old-fashioned, even though it has a long pedigree. Last year, at the height of the crisis, the primary dealers in the overnight money market started hoarding liquidity – and thus not lending money to other banks or for longer durations.

The Fed attempted to counter this by offering much greater liquidity to the markets through its discount window. This offers to lend to far more banks against much wider collateral at a premium, currently half a percentage point, to the Fed Funds rate. But such was the sense of stigma that banks generally refused to use this.

Instead, the Fed found its liquidity operations bypassed as US commercial banks furtively accessed huge amounts of liquidity from the Federal Home Loan Banks. These wholesale government-sponsored bank co-operatives offered loans against housing-related collateral on an unprecedented scale, reaching an annualised rate of $750bn (£385bn, €517bn) during the third quarter of 2007, the last for which data is available.

However, in December, the Fed embarked on a new policy: it introduced a temporary auction facility, which essentially allowed all banks to bid for a predetermined amount of one-month money in return for a wide range of collateral. The TAF provided a new tool for the Fed to bypass the primary dealers. Since this new tool appears to have worked relatively well, the Fed is now likely to make the TAF permanent and use it as its main source of crisis liquidity support in the future.

In continental Europe, by contrast, the ECB started the crisis with the advantage of having policy tools that were more modern and flexible than in the US. There was another, unexpected advantage. When the ECB was created a decade ago, it essentially combined all the rules of its member central banks with respect to the collateral that private-sector banks could use when they received central bank funds. This combined list was wide-ranging, which meant that when the liquidity freeze struck, private-sector banks could post all manner of assets – ranging from mortgage loans to government bonds – as collateral to get funds.

The Frankfurt-based bank also displayed flexibility by stepping in early to lend money for three months, rather than just overnight. This helped to soften a painful crunch in the three-month money markets.

The ECB, however, has not always been quite as generous as perceived. Though the bank grabbed headlines in August when it started lending much more than normal, what attracted less attention was that shortly after pumping in the liquidity, it extracted it again. To be able to control overnight interest rates, it insists commercial banks keep a pre-defined amount of money on its books in Frankfurt and penalises banks that hold too much. So, if it pumps money in on one day, unless it extracts the cash soon after, commercial banks will be desperate to lend the money to avoid penalties, thereby sending overnight interest rates down and undermining the ECB’s ability to keep them at the desired level.

The ECB was also reluctant to help European banks get access to dollars via a currency-swap arrangement with the Fed, and only agreed to this in December – long after the Fed proposed it.

But of all three banks, it is the Bank of England that has come under most fire for its apparent lack of flexibility, due to the spectacular implosion of Northern Rock, a regional mortgage lender, and the fact that Mervyn King, the bank’s governor, appeared to dismiss concerns about banking stress early in the crisis. These criticisms of inflexibility have been only partly justified. The Bank started the crisis with a set of money-market operations that were, in many ways, the most modern of any central bank, with an extensive suite of options for crisis-management…

One striking feature of this year’s global market turmoil is that money markets in Japan have been relatively calm. So calm, indeed, that when banks found it hard to raise finance in euro or dollar markets last autumn, many turned instead to the yen sphere.

In part, this reflects the fact that Japanese banks are less exposed to subprime risk. However, another key issue is that the Bank of Japan is now widely considered to be adept at managing its local money market – partly because it, unlike other G7 banks, has had extensive recent experience of quelling crises.

“We have a living, institutional memory of the ordeal of the past decade. Many ways of operation were invented and developed in those days,” says Hiroshi Nakaso, head of markets at the Bank of Japan. “We didn’t need new operations [last year] because we already have the necessary toolkit”, developed during the 1990s.

The big three central banks that have been at the eye of the storm all accept that there are now lessons to be learnt from this saga. Indeed, they have already started trying to change. In December the banks collectively announced a new co-ordinated set of measures, which included a number of country-specific policy U-turns – such as the Bank of England’s decision to accept mortgages as collateral. The system of central banking operations across the western world is starting to look a little more harmonised.

All the central banks, for example, can now accept a much wider list of collateral in their lending. They all now have greater tools to be able to lend at greater maturities – such as three months, say – and to change the timing of their lending to the banking system to iron out sudden crises of liquidity. They have started to embrace the notion of lending in others’ currencies, through, say, a euro-dollar swap. Last – but not least – officials at all three banks now firmly agree that if a stigma is attached to any of their policy tools, they simply will not work.

However, the huge challenge for the central banks now is how to take these lessons and create a more intelligent framework for the future. One lesson that many commercial bank treasurers have drawn from recent months is that they need to be adept at managing – if not arbitraging – subtle differences between different national money-market regimes. Until last summer this was not an issue that many bank boards worried extensively about, since few bank managers ever believed that liquidity was likely to dry up across the board. Indeed, so little attention was paid to the issue by German banks, for example, that some established dollar-based structured investment vehicles in Europe – even though they would not be able to access American funding easily in a crisis.

Similarly, Northern Rock’s business model was built on an assumption that it could always securitise its mortgages – even though it was operating in a regime that had had no mechanism to accept these mortgages as collateral.

The central banks are now considering whether to harmonise the collateral they accept. One senior European official at a central bank says: “On collateral management we have much progress to make on a national level and in terms of international management”. Jamie Caruana, the IMF’s head of monetary and capital markets, said there was “enormous” scope for convergence in central bank liquidity operations.

Nevertheless, harmonisation is not going to be a simple process. Central bankers understand that they cannot simply offer to lend against any bank assets because that gives an incentive for banks to hold much riskier assets. One central banker jokes that if he was willing to lend against the overcoats of banks’ managers, you would soon expect to see a marked improvement in winter fashions among bankers.

A second key issue now under debate is how to lend at greater maturities – say three months – if a crisis hits that corner of the market. Again, this is an issue of balance, since term lending often has consequences for interest rates overnight and can create havoc with monetary policy.

Meanwhile, central bankers are now considering two further ideas too: leaving currency swap arrangements in place to be used at moments of crisis; and lending unlimited amounts overnight at a very low penalty rate if the circumstances become so serious. This would effectively be to take the balance sheets of banks within the central bank.

If the central bankers reach an agreement on how to move forward on these issues, they could gain a better arsenal of policy tools to use next time a crisis strikes. Better still, if such tools are already in place, they could be pulled out with less drama – and thus trigger less panic. But as ever in central banking, policymaking remains a balancing act. Do too little or only act in the most grave circumstances and you threaten to increase the stigma associated with your operations, so they are ineffective. Do too much and you run the risk that bankers will take advantage and so you generate more crises by your actions. No one said central banking was easy. And none of the central bankers gathering in Tokyo last weekend was willing to bet that their current test is yet finished.

The primary role of a central bank in a modern advanced economy is to set the price of money – the interest rate. Large commercial banks are generally compelled to hold a certain proportion of assets at the central bank and in return receive risk-free central bank money, the equivalent of large bundles of notes and coins.

By distributing central bank cash in return for loans of commercial banks’ assets, central bankers set the overnight price of money, which helps regulate demand and inflation. Most other interest rates depend to some degree on the overnight risk-free rate, but also on the riskiness of lending. This leads to many interest rates bearing only passing resemblance to the overnight risk-free rate. Central banks cannot control these directly.

In a crisis, central banks have enormous firepower to drown financial institutions in cash. But if they throw money at a crisis, they face two risks.

First, they send the overnight interest rate tumbling because banks have too much cash and all try to lend it out. Inflation follows. Second, they send the signal they are always ready to bail out banks and encourage riskier practices in future.

It is balance between crisis-resolution and sensible monetary policy that is so difficult to strike and more of a dark art than a science.

One of the best ways to measure tensions in the money markets is to look at the difference between three-month bank borrowing costs and the overnight index swap in three months’ time. It shows the premium banks have to pay for short-term funds compared with completely risk-free borrowing.

This chart shows that borrowing costs surged dramatically in early August in the sterling, dollar and euro markets. But from mid-August, slight differences emerged, which appear to have reflected the different policies taken by central banks. Most notably, eurozone borrowing costs were more stable than in the other two markets, since the cost of borrowing euros never spiked as sharply as in sterling or dollar markets.

Nevertheless, these differences are not that dramatic, and by late last year all three markets were broadly moving in tandem – nothwithstanding the differences in their regimes. It is thus hard to conclude on the basis of this evidence that any central bank was dramatically more successful than any other.

One thing that is crystal-clear, however, is that borrowing costs have fallen sharply in all three areas since the joint policy announcements of December 12. That supports the argument that central bank action tends to be most powerful when it is clearly co-ordinated.