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, but the frequency at which they engage in these permanent purchases have become increasingly rare. The last time was on 3 May 2007.
In addition to permanent operations, the Desk injects funds into the banking system on a temporary basis using repurchase agreements. They do this with a set of 20 qualified “primary dealers.” These are mostly large banks. 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. 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. 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.
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).
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. 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.
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.
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.
 The Fed must buy ‘second hand’ in the sense that the Fed cannot buy new T-bills directly from the Treasury.
 In addition to buying securities to add to their portfolio, the Fed also rolls over maturing securities during the auctions that occur regularly.
 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 .
 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 .
 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 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!
 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.
 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.
 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.