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. |

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|This article may be reproduced with appropriate attribution. See Copyright (below). |

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