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The Art of Crisis Management:
Auctions and Swaps
Stephen Cecchetti
16 December 2007
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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.
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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.
[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 www.voxeu.com/index.php?q=node/466 .
[4] You can see the list at www.ny.frb.org/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 www.voxeu.com/index.php?q=node/748 .
[6]
This
information
is
released
every
day
at
www.ny.frb.org/markets/omo/dmm/fedfundsdata.cfm .
[7] In standard open market operations, the Fed accepts only U.S. Treasury, Agency, or AAArated fully guaranteed mortgage-backed securities. For these auctions the Fed will accept
almost
anything. The
list,
which
you
can
view
at
www.frbdiscountwindow.org/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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