Creative Act Of Central Banking

(originally published on December 22, 2007)

 

Following limited success of its prior attempts at defusing the crisis by manipulating the more commonly used tools in its arsenal (Open Market Operations, Federal Funds Interest Rate and Discount Window Interest Rate), the Fed unveiled a trump card this week to control the flow of credit in the economy : the Term Auction Facility.

To better understand this, lets get a bit of a background to the current resurgence of the credit crisis. After seemingly letting-up since mid-September, the spread between the one-month LIBOR rate (at which banks make non-collateralized loans to each other) and the Fed funds rate spiked up in late November and continued to rise ever since. Banks have refrained from lending to each other fearing the quality of assets on the balance sheets of potential borrowers. Since banks had enough trouble figuring out the value of the assets they possessed, they figured that other banks must be facing the same problems. The end result was a near-paralysis in inter-bank lending markets.

 

Widening spreads between one-month LIBOR and the effective Fed Funds rate

 

The initial reaction from the central banks was typical. The Fed resorted to temporary injection of funds into the banking system through repurchase agreements by way of open market operations through a set of 20 qualified 'primary' dealers. In addition, the central bank engaged in discount lending, acting as a lender of last resort, under the assumption that during a crisis, solvent but illiquid banks could go to the central bank for a loan that would be made at penalty rates and on good collateral. So when the interbank-markets shut down, theory suggests that the banks should have gone and borrowed at the central bank's discount window.

But as seen in the chart below, total volume of borrowing from the Federal Reserve in the week ended Dec 5 was a mere $342M. Further, Federal Reserve data indicates that in three out of ten days since the crisis started, the maximum trade in the Fed funds market exceeded the discount lending rate, i.e. banks were willing to pay more to borrow from each other than what they would have to pay to borrow from the Fed. Banks' unwillingness to borrow from the Fed's discount window could be attributed to the stigma of being branded uncreditworthy (“you only borrow from the Fed if nobody else is willing to lend to you”).

 

Sudden spike in borrowings from the Fed

 

Thus, while central banks had adequate tools to push funds into the banking system, there was no effective way to distribute it to corners that needed it the most. The Fed can get liquidity to the primary dealers, but with the breakdown of the distribution system, there is no way to ensure that those reserves are then lent to banks that need them. Further reductions in the Fed funds rate will achieve other objectives, but will not fix this problem. Lowering the target Fed funds rate further will only provide additional liquidity reserves to the already flush primary dealers. Additionally, with true globalisation of the financial system (refer the global nature of the sub-prime meltdown driven by essentially US mortgage defaults), dollars have been in short supply outside the US as well, thereby necessitating some cross-border intervention to meet the needs of banks in non-US countries that are short of US dollars.

With this background in place, last week's announcement of a Term Auction Facility (TAF) by the Fed seems like a creative act of central banking. The Fed announced auctions of reserves for terms upto 35 days, allowing all banks (7000+ banks, not just the 20 primary dealers) to participate, with a broader array of collateral accepted than in the standard repo operations. The TAF is also different from the discount window as it is for a fixed term and through an auction (removing the need for banks to come hat in hand, thereby hopefully avoiding the stigma attached to the discount window) with the Fed being the primary determiner of its quantity and timing (not private banks). Also, 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. While the concept is not new, our research indicated that no non-US central bank had ever offered dollars in their open market operations before.

So what do we infer from this? At its most basic level, TAF is simply another mechanism for doing open market operations. However, this certainly goes a bit deeper. Open market operations are conducted by central banks to change the size of its balance sheet or the composition of the assets they hold. The former is the traditional approach to central banking aimed at maintaining the Federal funds rate at its target level. The latter, in contrast, is what the TAF is all about... aimed at shifting assets from US Treasury securities (purchased through permanent and temporary open market repurchase operations) to some of the lower-quality loans such as MBS including sub-prime backed assets, thereby hopefully reducing the risk premiums charged currently in the inter-bank lending markets. The Fed is essentially offering to absorb some of the risk (or the perception of it) that is presumably the root cause of the market's unwillingness to purchase the risky CDOs and MBSs.

In the best case (and most likely in our opinion) scenario, the Fed will suffer no loss and possibly avert to a certain extent a nasty turn in the financial markets ridden with defaults and bankruptcies. In the worst case, the defaults will only be postponed and the Fed will absorb some losses just like everybody else (the only way the Fed can absorb these losses is by more money creation which is one way of dealing with the serious risk of deflation that a major financial turmoil like this could lead to).

This concerted effort from central banks to ease the credit market gridlock seems to be finding some initial success with money market rates declining for four consecutive days this week. The impact was a lot more pronounced in the Eurozone with the cost to borrow in euros plunging a record 50 bps after the ECB injected an unprecedented $500Bn into the banking system on Dec 18 in an attempt to ease the liquidity crunch at year-end. The Fed conducted two of four planned auctions, pushing $40Bn into the banking system. Financial institutions stampeded for this liquidity, submitting $57.7 billion in bids for Friday's auction, a bid-to-cover ratio of 2.88, for an effective rate of 4.67% on Friday, just 8 bps short of the discount window rate. Clearly the discount window rate seems tight and the Fed would do well to reconsider this rate in the next meeting.

While there is no way to be certain of whether these manouevres would succeed, we have to remark that a spectacularly creative chapter in central banking is being written!