An excellent article by Willem Buiter (Professor of European Political Economy at the London School of Economics and formerly a member of the Monetary Policy Committee of the Bank of England and Chief Economist at the European Bank for Reconstruction and Development) and Anne Sibert (Professor and Head of the School of Economics, Mathematics and Statistics at Birkbeck College, London; and an advisor to the Committee for Economic and Monetary Affairs of the European Parliament) at VoxEU which argues that in a world where credit intermediation has shifted from the banking system to the capital markets, the old notion of the central bank role in crisis of “lender of the last resort” is not only outmoded but is producing actions that are at best not very effective and in some regards counterproductive. Buiter and Siebert instead argue for a new central bank role of “market maker of last resort”:
Central banks have not been doing the job of market maker of last resort effectively, indeed they have barely been doing it at all…. Covering the central bank’s posterior is less important than preventing avoidable financial instability.
This is a harsh indictment and a provocative proposal from unimpeachable experts. While their critique of the central bank interventions of last week are broadly similar to that of other observers, such as Paul de Grauwe and Nouriel Roubini, they are far more specific in their criticisms and their vision of how a modern central bank should operate.
The paper is long but very much worth reading. I’ve excepted some major sections:
Last week’s actions by the ECB, the Fed and the Bank of Japan were not particularly helpful – a classic example of trying to manage a credit crisis or liquidity squeeze using the tools suited to monetary policy-making in orderly markets. Monetary policy is easy; preventing or overcoming a financial crisis is hard; managing the exit from a credit squeeze without laying the foundations for the next credit and liquidity explosion is harder still. Central bankers should earn their keep by acting as market makers of last resort.
When banks were the main providers of credit, the financial stability mandate of central banks could be summarised as their lender of last resort function: in times of crisis, lend freely, at a penalty rate and against collateral that would be good in normal times but may be impaired in times of crisis. The counterparties of the central bank in these lender of last resort operations were commercial banks (shorthand for deposit-taking institutions whose main liabilities were deposits withdrawable on demand and subject to a sequential service (first-come, first served) constraint. Their main assets were illiquid loans. This financial structure invited bank runs when confidence in the banks was undermined, for whatever reason. In the days when banks were the dominant intermediaries, a credit crunch or liquidity squeeze manifested itself in the inability of banks to borrow; a lender of last resort that targeted banks was the right vehicle for dealing with liquidity crises and credit squeezes in that set-up.
These days are gone in the globally integrated modern financial systems characterising all advanced industrial countries and an increasing number of emerging markets.
Today, external finance to non-financial corporations and to financial institutions is increasingly provided not through banks but through the issuance of tradable financial instruments…. Now that financial markets (and non-bank financial institutions) have increasingly taken over the function of providing credit and all forms of finance to deficit spending units, a credit crunch or liquidity crunch manifests itself in a different way from the world described by Walter Bagehot’s lender of last resort (see Walter Bagehot (1873), Lombard Street: A Description of the Money Market).
Today, a credit crunch or liquidity squeeze manifests itself as disorderly financial markets….. The precise way in which such micro-market failure (the failure to match willing buyers and sellers at prices acceptable to both) occurs differs for exchange-traded instruments and over-the-counter financial instruments (instruments for which bilateral bargaining over a deal is the normal exchange mechanism), but the solution is the same: the central bank has to become the market maker of last resort.
The mechanics of the market maker of last resort function
The market maker of last resort function can be fulfilled in two ways. First, outright purchases and sales of a wide range of private sector securities. Second, acceptance of a wide range of private sector securities as collateral in repos, and in collateralised loans and advances at the discount window.
Outright purchases and sales of illiquid private sector securities
The first and most direct way to discharge the market maker of last resort function is through open market operations in a much wider range of financial instruments, especially private sector securities, than central banks normally are willing to trade in. Open market operations here means outright sales and purchases of financial instruments (i.e. not collateralised loans or advances).
As regards making markets in private sector securities during times of crisis, central banks appear to have moved in the opposite direction to what the logic of financial system development would suggest. Since 1933, “…the Federal Reserve has gradually narrowed the scope of securities that it purchases (or with which it conducts repurchase agreements in the open market” (David H. Small and James A. Clouse (2004), “The Scope of Monetary Policy Actions Authorized under the Federal Reserve Act”, Board of Governors of the Federal Reserve System Research Paper Series – FEDS Papers 20004-40,July; this is also the source from which the information on the Fed’s eligible counterparties and eligible securities is taken; see also the Federal Reserve Act itself)….
For outright sales and purchases in the open market to be effective instruments with which to address a credit crunch, the Federal Reserve should be able to buy and sell outright a range of private sector credit instruments…. However, while the Federal Reserve Act contains no language authorising the Federal Reserve to purchase corporate bonds, bank loans, mortgages, credit-card receivables or equities, it also does not forbid it. After all, the Federal Reserve Act also does not authorise the sale or purchase of options, yet the Fed of New York sold options on overnight repo transactions with exercise dates around the 1999 year-end, to forestall any Y2K problems.
The history of the ECB, which did not start operations until January 1, 1999 is short. Its legislative mandate and operating practices are less encumbered by history than those of the Fed.
The ECB accepts, in principle, a very wide range of both marketable and non-marketable assets both for outright purchase and as collateral in repos or collateralised loans (see, European Central Bank (2006)….
There are some strange restrictions. For instance, in the case of ABS, the “cash flow-generating assets backing the asset-backed securities must “… not consist, in whole or in part, actually or potentially, of credit-linked notes or similar claims resulting from the transfer of credit risk by means of credit derivatives.” (ECB(2006)). Why credit risk, or derivatives based on credit risk would be treated differently from market risk, and derivatives based on market risk, is a deep mystery. Functionally, risk is risk; as long as it can be priced, it is fungible.
There is also the rather wimpish restriction that the debt instrument must be denominated in euro, which means that it cannot be helpful to BNP Paribas in establishing a market for the (presumably dollar-denominated) CDOs backed by pools of US subprime mortgages. Why would the ECB wish to avoid collateral denominated in currencies other than the euro? Exchange rate risk can be hedged….
Fortunately, the list of eligible counterparties and eligible instruments for the ECB and the ESCB is not fixed by law. It is decided by the ECB’s Governing Council and can be changed at the drop of the collective hat. We would argue that the hat has dropped and that, in extremis, the ECB should consider the broadest possible set of counterparties and the most unrestricted possible set of eligible financial instruments….
The lender of last resort function and the discount window
While the market maker of last resort function is a defining function of the modern central bank, the traditional lender of last resort function can also be relevant in the resolution of a crisis. Repos are collateralised open market operations; we define the lender of last resort function as bilateral transactions between the central bank and a private counterparty at the discount window. With the diminished importance in the financial system of banks and similar deposit-taking institutions, it is important that the central bank be able to exercise this function also vis-à-vis a wider range of counterparties, and against a richer array of collateral than that traditionally offered by commercial banks.
Eligible counterparties and eligible securities in a crisis
Fortunately, the Federal Reserve Act (1913) allows the Federal Reserve to lend, in a crisis, to just about any institution, organisation or individual, and against any collateral the Fed deems fit….
It is, of course, key that such (re)discounting be at a penalty rate and against collateral deemed adequate by the central bank. The Fed’s discount window has three different facilities and associated rates; the benchmark primary credit rate currently stands at 6.25%, 1.00% above the Federal Funds target rate; the secondary and seasonal credit rates exceed the primary rate. The ECB’s Marginal Lending Facility currently charges a 5.00% rate, also 1.00% above the ECB policy rate, the Main Refinancing Operations Minimum Bid Rate, which stands at 4.00%. Financial instruments eligible for collateral in discount operations (or repos) are valued at their market prices and a ‘haircut’ is applied to them.
The combination of the 100bps extra cost of the discount window over the policy rate and the haircut would be a sufficient incentive not to abuse the discount window if there were a meaningful market price at which the securities offered as collateral could be valued. Of course, in a crisis, such market prices cannot be found. This is where the job of the central bank becomes difficult, politically contentious and of vital importance. In its discount window operations during crisis times, that is, when acting as lender of last resort to some institution or IPC, the central bank will also often have to act as market maker of last resort because it will have to value financial instruments for which no meaningful market price is available.
How have central banks managed liquidity crises and credit crunches?
When acting as market maker of last resort, as when acting as lender of last resort, the central bank inevitably plays a central role in assessing and pricing credit risk; through this, the central bank will have a profound influence on the allocation of credit in the economy (see Small and Clouse (2004)). While the central bank should not be in this business during ordinary times, when markets are orderly and price formation and price discovery proceeds without the direct intervention of the central bank, it cannot avoid being in this business when markets are disorderly and fail to match buyers and sellers of securities.
Central banks have not been doing the job of market maker of last resort effectively, indeed they have barely been doing it at all. Following the stock market collapse of 1987, the Russian default of 1998 and the tech bubble crash of 2001, all that the key monetary authorities have done is (1) lower the short risk-free interest rate and (2) provide vast amounts of liquidity against high-grade collateral only, and nothing against illiquid collateral. The result has been that the ‘resolution’ of each of these financial crises created massive amounts of high-grade excess liquidity that was not withdrawn when market order was restored and provided the fuel that would produce the next credit boom and bust. By focusing instead on illiquid collateral, it should have been possible to achieve the same effect with a much smaller injection of liquidity.
The incipient financial crunch of mid-2007 has not, thus far, been met with interest rate cuts by any of the key central banks – the Fed, the ECB, the Bank of Japan and the Bank of England. That is just as well, because there is, as yet, nothing excessive about the level of the (default-) risk-free short nominal interest rate levels in the US, the Eurozone, Japan or the UK. A credit crunch is the time for central banks to start worrying about the next credit boom. Lowering the risk-free rate is not the solution to any credit crunch/liquidity crisis problem. It only encourages further borrowing and leverage by those already excessively prone to such acts.
The problems we are seeing today are the result of four to five years of (1) excessively low risk-free interest rates at all maturities in the US, Euroland and Japan, and (2) ludicrously low credit risk spreads across the board (not just in the subprime mortgage markets).
These two asset market anomalies resulted in many highly leveraged open positions that were predicated on the persistence of low risk-free rates and low spreads. Regulatory and supervisory failures compounded the magnitude of the debt and credit risk bubble that had been created. The supervisory and regulatory failures in the US mortgage markets (and not just at the subprime end of the spectrum) are so manifest that those on whose watch they occurred ought to be called to account.
When the great normalisation finally came (starting with rising risk-free real and nominal long-term rates and rising risk-free nominal short-term rates, and picking up steam with the normalisation of credit risk spreads, starting from the US subprime residential mortgage markets and derivatives based on them), a growing number of these highly leveraged open positions went belly-up. At the junk end of the market, realised default rates began to be recorded that exceeded those that had been priced into the primary and derivative securities issued in past years in these markets.
Some funds heavily invested in these mis-priced subprime mortgage-based securities went bankrupt. That is as it should be. Others, as in the case of three BNP Paribas funds exposed to the US subprime mortgage market, suspended the ability of investors to withdraw their investments from the funds, because the funds’ managers and their BNP Paribas owners argued they had no way to value the funds’ assets, which had become illiquid in the turbulent asset market conditions of the past week.
It is possible, indeed quite likely, that more funds that made highly leveraged bets whose success depended on the continuation of low risk-free rates and low credit spreads, will go bankrupt – and not only funds exposed to the US subprime mortgage market; the problem of financial hubris was much more widespread than that. Financial institutions heavily exposed to such funds and insufficiently diversified in other ways, may also go bankrupt. Among the ranks of the potential victims could be investment banks and deposit taking institutions. That again is as it should be, and does not call for intervention. It certainly does not call for lower central bank policy rates. Darwin must have his pound of flesh also in the financial markets, lest the central banks create a credit risk put that would put Greenspan’s equity puts in the shade.
What is not as-it-should-be is that fear and panic causes financial markets to dry up, making it impossible for firms that need to raise cash to do so either by selling assets that would have realisable value in orderly markets, or by borrowing using these assets as collateral. Even if the assets are impaired, there should still be a market to sell them at a discount appropriate to the central bank’s assessment of its risk of default and the central bank’s assessment of the orderly market price of risk. Collateralised borrowing against such impaired assets should likewise be possible at the same default-risk-appropriate discount (as assessed by the central bank). If the markets for selling impaired assets or for borrowing using impaired assets as collateral seize up and cease to function, the central bank must step in to perform its market maker of last resort function.
During the past week, the ECB, the Fed and the Bank of Japan have injected well over $200 billion worth of liquidity into the markets to stop the relevant private benchmarks from rising above their policy rate targets (in the US, the Federal Funds rate was threatening to rise sharply above 5.25%; in Euroland, the overnight interbank rate was threatening to rise above 4.00% and in Japan the overnight rate likewise was threatening (somewhat less convincingly) to rise above 0.50%). We consider this action not to have been particularly helpful: even where the open market purchases were collateralised against mortgage bonds, the central banks chose high-grade mortgage bonds for which there still was a private market and price rather than illiquid mortgage bonds for which the market had stalled and no market price was available. This was a classic example of central banks trying to manage a credit crisis or liquidity squeeze using the same tools and routines they use to make monetary policy in orderly markets.
A credit crunch and liquidity squeeze is instead the time for central banks to get their hands dirty and take socially necessary risks which are not part and parcel of the art of central banking during normal times when markets are orderly. Making monetary policy under conditions of orderly markets is really not that hard. Any group of people with IQs in three digits (individually) and familiar with (almost) any intermediate macroeconomics textbook could do the job. Dealing with a liquidity crisis and credit crunch is hard. Inevitably, it exposes the central bank to significant financial and reputational risk. The central banks will be asked to take credit risk (of unknown) magnitude onto their balance sheets and they will have to make explicit judgments about the creditworthiness of various counterparties. But without taking these risks the central banks will be financially and reputationally safe, but poor servants of the public interest.
So: monetary policy is easy; preventing or overcoming a financial crisis is hard; managing the exit from a credit squeeze without laying firm foundations for the next credit and liquidity explosion is harder still. Our central bankers should earn their keep by acting as market makers of last resort. Covering the central bank’s posterior is less important than preventing avoidable financial instability.