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. 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.
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.
Good article by the professor.
The question of whether more fed rate cuts are appropriate is of course debatable. Nouriel Roubini has an excellent post yesterday in defense of cuts.
Either way, given that the ‘stigma’ of discount window borrowing is a problem, and given that the professor’s interpretation is that the auction system will help avoid that, what is the argument against lowering the discount rate further (which is what the market was hoping for)?
If a carmaker chooses not to make or to make and not sell a car, surely that is its own business.
So too if a bank chooses not to lend to another bank except at high rates, what business is it of yours?
Frankly I do not understand your unwillingness to attempt to distinguish between a competitive private and or rigged government market price and availability of funds and willingness to loan these out.
My question to you is at what rate would you lend 500 million quid?
“Clearly, they were worried about the quality of the assets on the balance sheets of the potential borrowers.” So the reason banks are willing to pay the higher LIBOR rate for overnight loans is that they are probably less liable to scutiny of the assets offerred as collateral. Let’s call it the incredible premium. This suggests that the Fed’s plan to accept some of these assets as collateral should include the right to sell it on the open market so as to establish a price. Of course, the Fed would take a loss (and would then be known as the loser of last resort) but so what. The issue apparently is transparency.
A very interesting quote from Steve Cecchetti’s article:
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. […] 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.
This leads to the question of whether the highest TAF auction bid submitted on Monday will be higher than the discount rate. After all the TAF will be anonymous and will not have the public stigma of borrowing at the discount window. Based on the Cecchetti quote, the answer will almost certainly be yes (because, basically, that’s the situation we’re already in).
However, we’ll probably never know about it if it happens, because all auction winners will pay the lowest possible winning rate (the “stop-out rate”). Thus, in the TAF, the Fed will lend money for less than nearly all auction winners would actually be willing to pay. Only the stop-out rate will be announced, and no information about individual bids will be made public.
Still, we have at least the theoretically possibility that the TAF rate will turn out to be higher than the discount rate, if $20 billion worth of high bids are submitted. Wouldn’t that make for an interesting day on the markets.
To clarify, the famous Fed “rate” awaited breathlessly by Wall Street when Ben Bernanke and the FOMC meet every six weeks or so, and recently cut again to 4.25%, is in fact the “federal funds target rate”. The Fed targets this rate by conducting open market operations (repos and so forth). However, what this fed funds rate actually applies to is overnight lending of reserves by banks to one another, and each individual transaction is negotiated between the banks involved. Thus if Bank A lends overnight to Bank B, the interest rate will in general not be exactly 4.25%, but could be something higher.
The Cecchetti quote says that some particular “Bank B”s out there are already paying more than the discount rate… that is, they are paying more to borrow from some fellow bank than they would to borrow from the discount window!
This is fairly arcane stuff, so I would appreciate if someone would tell me I’ve got this wrong.
anon @ 4:34
the actual funds rate is called the ‘fed effective’ rate, which is the daily average of actual trades, usually slightly different than the target rate
the fed basically adjusts reserves in line with closing any gap between the effective and the target as they go along
you can google a daily time series on the fed effective going back 50 years