We wondered ever since the Fed established and then repeatedly increased the size of its Term Auction Facility, which now provides $150 billion of support to the US banking system, how the central bank would ever be able to wind down this program. It certainly can’t do it when the financial system is fragile, and banks will argue that the withdrawal will hurt their operations even when the economy is in better shape.
We aren’t alone here. Richmond Fed president Jeffrey Lacker has reservations about these new facilities (rather late, isn’t it?). Note, however, that at some are proving to be a success, in that usage is declining as market conditions have improved, specifically, the Term Secured Lending Facility and the Primary Dealers Credit Facility. But the TAF has grown rapidly, from $40 billion, which was seen as an extraordinary number at the time of its inception, to $150 billion in less than six months, and there no question that the Fed would increase it yet again if spreads in the interbank market signalled distress.
Gillian Tett comes to more or less the same conclusion based on her experience in Japan. From the Financial Times:
A decade ago I lived in Tokyo, where I wrote about Japan’s banking woes. For several nail-biting years, I watched as the Bank of Japan unveiled a stream of ever-more creative measures that were designed to combat the risk of a financial meltdown.
By the start of this decade, this crisis was – finally – ebbing away. So when I left Tokyo in 2001, I naively assumed that the BoJ’s “emergency” policies were destined to vanish too. Not entirely so. As Tadashi Nakamae, a Japanese economist, pointed out to me, one “emergency” practice from that era that has not gone back on the shelf is the idea that the BoJ should buy lots of Japanese government bonds.
Ever since the BoJ deployed this “temporary”, crisis-busting step – supposedly to help the banks – the Ministry of Finance has become fond of keeping long-term bond yields down. Thus, whenever the BoJ threatens to withdraw its JGB support, the Ministry blocks the idea on the grounds the move could unleash more financial turmoil.
It is a salutary tale that western policymakers would do well to note. In the past 10 months, as a financial crisis has swept through western markets, US and European central banks have also produced all manner of crisis-busting, money-market manoeuvres. And, perhaps unsurprisingly, some of these seem to have been copied from 1990s Japan…. the more I look at these measures, the more I wonder how the US and European banks will avoid the Japanese trap.
After all, if western central banks halt these emergency steps too fast, they could unleash turmoil again; but if they wait too long, they could breed a new form of financial addiction among private banks and politicians alike. And as any addict knows, addiction rarely disappears by itself. On the contrary, procrastination tends to make the problem worse, as habits become deeply ingrained – be that in Japan, or anywhere else.
The US Federal Reserve, for its part, appears to be keenly aware of this problem. And Timothy Geithner, New York Fed president (and himself an expert on Japan), has signalled his desire to avoid any Tokyo-style policy fudge by calling for a broader rethink of the regulatory structure. The Fed has also indicated that it will withdraw the generous liquidity support that it is providing to broker-dealers, after the Bear Stearns drama, by September.
But whether the Fed will actually meet this deadline remains an open bet. After all, brokers such as Lehman Brothers are hardly flourishing – and the prospect of the September deadline is already spooking the markets.
Yves here. If we don’t have a reversion over the summer, the Fed may be able to deliver on that promise, because, per the discussion, the use of the dealer facilities is waning. The TAF is the one the banks are hooked on.
Meanwhile, on the other side of the Atlantic, the European Central Bank has its own problems. The Frankfurt-based group has not set any deadline for scaling back its programme of emergency money market support. However, some officials are becoming concerned about the addiction patterns this is breeding.
More specifically, there is concern that private sector banks have little incentive to restart the mortgage securitisation market – precisely because it is so easy (and cheap) to get funding from ECB sources instead. But the ECB knows that if it tries to withdraw its aid before the securitisation market has reopened, it will face strong political criticism. Worse still, it could even hurt some banks.
Perhaps this dilemma will quietly resolve itself over time. After all, if banks recapitalise themselves over the summer and investors regain confidence, it should become easier to withdraw central bank support this year or next – or so the optimists hope.
But in the meantime I am told that many western banks are becoming increasingly creative about how they repackage their assets to get central bank support. Addiction, in other words, is not disappearing of its own accord. No wonder some bankers now joke that the “originate to distribute” model has quietly morphed into “originate to repo” pattern instead. It is indeed a difficult policy trap. Do not bet on an easy or smooth exit soon.