The Art of Crisis Management: Auctions and Swaps
The Art of Crisis Management: Auctions and Swaps
|Stephen Cecchetti |Print Email |
|16 December 2007 |Comment Republish |
|The financial crisis of 2007 is bringing out the creative side of the worlds central bankers. Finding traditional instruments |
|wanting, they spent the last month or so fashioning new tools and resurrecting old ones. Here are the FAQs on what they did, why|
|and what it might mean. |
| |
|The financial crisis of 2007 is bringing out the creative side of the worlds central bankers. Finding traditional instruments |
|wanting, they spent the last month or so fashioning new tools and resurrecting old ones. Then, on 12 December at 9am in |
|Washington and Ottawa, 2pm in London, and 3pm in Frankfurt and Zurich five central banks (or systems of central banks) made |
|their joint announcement. |
|What did they do? |
|· The Federal Reserve is initiating something called a Term Auction Facility (TAF) to auction reserve funds to |
|American banks. This is new – really new. |
|· The Bank of Canada and the Bank of England expanded the collateral they would accept in their open market |
|operations. |
|· The Federal Reserve set up swap agreements with the European Central Bank and Swiss National Bank whereby each |
|can obtain dollars from the US in exchange for their own currency, and then proceed to offer dollars to banks in their own |
|countries. In and of themselves, the foreign exchange swaps are not new. But, as far as I know, no non-US central bank has ever |
|offered dollars in their open market operations before. |
|Central bankers are extremely conservative people, they work deliberately. Improvisation does not come easily or naturally. |
|Their first rule is to do no harm. But this fall, financial conditions have left these normally cautious policymakers with |
|little choice. After improving for several months, the banks are swooning again. To put it more dramatically, in mid-November |
|the financial system looked ready to leave intensive care, but then things took a sudden turn for the worse. Let me try to |
|explain what has happened, what these policy actions are designed to do, and finally, why I am skeptical that they will work. |
|Why did the subprime crisis take a turn for the worse recently? |
|Simply stated, the problem is that banks are unwilling to lend for anything longer than a few days. Things are particularly |
|acute in the market for dollars. We can see this in the fact that dollar LIBOR rates – that’s the London Interbank Offer Rate at|
|which large banks make each other uncollaterized loans – spiked up. Prior to the start of the turmoil in early August, the |
|one-month dollar LIBOR rate was typically 5 to 10 basis points above the federal funds rate target (a basis point is one |
|one-hundredth of a percentage point, so that is 0.05 to 0.10 percentage points). In early August, this spread suddenly grew to |
|more 30 basis points, peaking at 75 on 18 September. |
|By the end of October, things seemed to be calming down with the LIBOR spread falling back below 10 basis points briefly and |
|staying below 20 basis points through most of November. Then, suddenly on 28 November things got worse again. And the second |
|wave is at least as bad as the first. |
|Why are big private banks unwilling to lend to each? |
|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. |
|What are the Central Banks’ traditional policy levers? |
|Those of us that teach about central banks begin by explaining to our students that in order to meet their medium-term |
|stabilization objectives of price stability and maximum sustainable growth, policymakers adjust the overnight interbank lending |
|rate; in the US that’s the federal funds rate. To do this, they manipulate the size of their balance sheet – changing the |
|quantity of securities they hold to adjust the level of reserves they provide to the bank system. In the United States, the |
|Federal Reserve’s Open Market Trading Desk (the “Desk”) does this in two ways. First, they engage in permanent additions to |
|their portfolio, buying US Treasury securities and holding them until maturity. They are legally required to do this in the |
|secondary market[1], but the frequency at which they engage in these permanent purchases have become increasingly rare. The last|
|time was on 3 May 2007.[2] |
|In addition to permanent operations, the Desk injects funds into the banking system on a temporary basis using repurchase |
|agreements.[3] They do this with a set of 20 qualified “primary dealers.” These are mostly large banks.[4] 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. |
|How do Central Bankers act as ‘lenders of last resort’? |
|The next part of the traditional central bank toolkit is discount lending and the central bank as a lender of last resort. The |
|idea is that during a crisis, solvent but illiquid banks can go to the central bank for a loan.[5] The theory is that these |
|loans are to be made at penalty rates – higher than the target for the overnight rate set by policymakers – and on good |
|collateral. |
|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. |
|Term Auction Facility (TAF): new – really new |
|Finally, we are now ready to discuss the actions of 12 December. The Fed announced that they are going to auction off reserves |
|for terms of up to 35 days, allowing all banks to participate and accept the same collateral that is accepted in discount |
|lending. This is different from open market operations because it involves all 7000+ banks, not just the 20 primary dealers, and|
|the collateral accepted is much broader than what is taken in the standard repurchase operations (‘repo’ in the jargon).[7] |
|The TAF is also different from discount lending in that it is for a fixed term and is through an auction. This may be a critical|
|change as it means that Fed determines the quantity and the timing, not the private banks. Banks do not come hat in hand to the |
|Fed asking for a loan, they simply bid at the auction – no stigma, one hopes. |
|Exchange rate swaps between Central Banks – why do they need money? |
|And then there are the swap agreements.[8] The point of these is that it allows non-US central banks to get dollars to their |
|domestic banks that need them. |
|It is hard to overstate the effort that has gone into all of this. Creating an entirely knew program, coordinating it among all |
|of the people involved, and making the announcement – that is no mean feat. And the technical challenges ahead are formidable as|
|well. It’s one thing to run an auction with 20 primary dealers bidding. It is something entirely different to do it with over |
|7000 banks eligible to bid.[9] |
|Target of the new actions: interest rate spreads, not just levels |
|Okay, so what exactly is the Fed trying to do here? At its most basic level, the TAF is simply another mechanism for doing open |
|market operations. It seems like one of those technicalities that we normally ignore as being irrelevant. To understand why they|
|are doing this, we need to think about the fact that the central bank can use operations to either change the size of its |
|balance sheet or the composition of the assets that they hold. The first of these is what we teach and understand. It is the |
|traditional policy directed at maintaining the federal funds rate at its target level. The second is different, and that’s what |
|the TAF is about. This new mechanism is aimed at shifting assets from US Treasury securities (that are purchased for the |
|permanent holding or taken in repurchase agreements) to some of the lower quality stuff that is accepted as collateral for |
|discount loans. And the purpose of this is to try to reduce the risk premia charged in the one-month and three-month interbank |
|lending markets. |
|Standard open market operations give the Fed control over the level of short-term interest rates. The purpose of the Term |
|Auction Facility is to give them a tool for influencing interest rate spreads.[10] |
|Will it work? |
|I sure hope so. But there is one piece of evidence that makes me worried. |
|The TAF 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. |
|But, there is still hope. |
| |
| |
|[pic] |
|[1] The Fed must buy ‘second hand’ in the sense that the Fed cannot buy new T-bills directly from the Treasury. |
|[2] In addition to buying securities to add to their portfolio, the Fed also rolls over maturing securities during the auctions |
|that occur regularly. |
|[3] While the Desk is authorized to engage in repos that are up to 65 days in maturity, the vast majority are overnight (or 3 |
|day when the weekend is coming). I describe the details of how these repurchase agreements work in an early article for Vox, |
|Federal Reserve Policy Actions in August 2007: Frequently Asked Question (updated) at index.php?q=node/466 . |
|[4] You can see the list at ny.markets/pridealers_current.html. |
|[5] I simply note here that in a crisis it can become almost impossible to distinguish illiquidity from insolvency. For a |
|discussion of this problem, see “Subprime Series, part 2: Deposit insurance and the lender of last resort” at |
|index.php?q=node/748 . |
|[6] This information is released every day at ny.markets/omo/dmm/fedfundsdata.cfm . |
|[7] In standard open market operations, the Fed accepts only U.S. Treasury, Agency, or AAA-rated fully guaranteed |
|mortgage-backed securities. For these auctions the Fed will accept almost anything. The list, which you can view at |
|discountmargins.pdf includes subprime credit card receivables at 60 percent of the outstanding |
|balance. That’s a far cry from a U.S. Treasury bill! |
|[8] Creation of the swap agreements require FOMC approval. This is a part of the explanation for the timing of the announcement,|
|the day after the 11 December meeting. Why everything had to wait for the next day after that meeting to be made public, I do |
|not know. |
|[9] The details of the TAF procedures reveal that banks are going to bid by phone, so each Federal Reserve Bank has had to train|
|a group of telephone operators to take these calls. |
|[10] I should note that when we get to the lecture on monetary policy and exchange rates, we teach that sterilized exchange rate|
|intervention has no impact. But sterilized intervention is a case in which the central bank changes the composition of the |
|assets on its balance sheet, without affecting the overall of its balance sheet. The TAF is exactly such a policy. |
| |
|This article may be reproduced with appropriate attribution. See Copyright (below). |
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