Under every central banker’s bed is a copy of “Lombard Street” by Walter Bagehot. Published in 1873, it argues that the central bank should act as a lender of last resort during crises to ensure that financial intermediaries have the resources to provide liquidity in asset markets. The name comes from the London base of Overend, Gurney and Company who in 1866 were the subject of the last run on a British bank before Northern Rock in 2007.
In response to today’s crisis, the US Federal Reserve has followed Bagehot’s prescription and injected significant funds into the intermediaries sector. But these actions do not appear to have been as effective as hoped. In particular, liquidity provision by intermediaries remained inadequate in many over-the-counter markets (see for example Brunnermeier 2009 and Bank for International Settlements 2009).
This has prompted the Federal Reserve to depart from Bagehot's recommendation and intervene directly in over-the-counter markets. In March 2009, Federal Reserve announced that it would purchase up to $1.25 trillion worth of mortgage-backed securities.
New interpretation: Demand-side liquidity contraction
This column therefore addresses two questions:
- Why didn't intermediaries use the cash supplied by the Federal Reserve to buy assets?
- Was it a good idea for the Federal Reserve to step in and buy assets directly?
In addition to Bagehot's emphasis on credit constraints limiting the supply of liquidity services, our model highlights the role played by “trading frictions” on the demand for these services.
Liquidity in over-the-counter markets is provided on a voluntary basis by broker-dealers such as large investment banks who match buyers and sellers and, in the event of large selling pressures, typically buy assets on their own account.
We focus on two forms of trading frictions within this market.
- First, finding counterparties takes time.
- Second, trade is bilateral with quantities and prices determined by bargaining.
We simulate a crisis in our theoretical market setup and find that when frictions are very small – such as in the market for Treasury securities – investors are very effective at directly providing liquidity to each other, making it unprofitable for intermediaries to step in. But when trading frictions are very severe, such as in subprime markets, investors demand very little liquidity services from intermediaries as a way to avoid costly transactions. Indeed, investors become reluctant to hold extreme asset positions because they anticipate that these positions will be very expensive to unwind.
This results in all investors ending up with a similar "average" asset position during crises and therefore not seeking to trade much, i.e. they demand little liquidity services from intermediaries. It is this low demand for liquidity services that in turn makes it unprofitable for intermediaries to provide liquidity.
As a result of this reduced liquidity demand, dealers do not provide any liquidity in our crisis scenario equilibrium. This lack of liquidity provision is socially inefficient in markets where intermediaries have a large degree of bargaining power. Indeed, the investors' low demand for intermediaries liquidity arise because investors anticipate that intermediaries will appropriate large fractions of the gains from unwinding their asset positions. So, while investors perceive low private gains from transacting with intermediaries, the social gains from transacting are much larger.
Our findings have three implications for monetary policy:
- First, borrowing constraints are not the only reason that intermediaries do not step in to buy assets at low prices during a crisis. Intermediaries in our analysis, for example, will sometimes not buy assets even though they have unrestricted access to cash. In such instances, injecting cash to support liquidity provision would be ineffective – intermediaries would hoard it instead of using it to purchase assets.
- Second, if the government acts as a "liquidity provider of last resort," if it purchases assets during the crisis in order to resell them when the economy recovers, equilibrium social welfare can increase. Since capital injections are ineffective, we ask whether there is room for the government to step into the interdealer market and accumulate assets on its own account, effectively acting as a “liquidity provider of last resort.”
- Third, if policymakers are able to implement policies that affect the structure of the market, they should aim to reduce the market power of financial intermediaries. Euronext, for example, managed to reduce dealers’ market power by requiring its Designated Market Markers to commit to a minimum spread (see Menkveld and Wang, 2009).
Bagehot, Walter (1873), “Lombard Street: A description of the money market” Wiley Investment Classics.
Bank for International Settlements (2009), “Over-the-counter derivatives market activity in the second half of 2008” Monetary and Economics Department.
Bernanke, Ben S (2009a), “Financial reform to address systemic risk” Speech at the Council on Foreign Relations, March 2009.
Bernanke, Ben S (2009b), “Four questions about the financial crisis” Speech at Morehouse College, Atlanta, April 2009.
Bernanke, Ben S (2009c), “The Federal Reserve's balance sheet” Speech at the Federal Reserve Bank of Richmond, 2009 Credit Markets Symposium, April 2009
Brunnermeier, Markus (2009), “Deciphering the liquidity and credit crunch 2007-2008” Journal of Economic Perspectives, 23:77-100.
Lagos, Ricardo and Guillaume Rocheteau (2009), “Liquidity in asset markets with search frictions” Econometrica, 77:403-426.
Lagos, Ricardo, Guillaume Rocheteau and Pierre-Olivier Weill (2009), “Crises and liquidity in over-the-counter markets” Working paper, NYU, UCI, and UCLA.
Menkveld, Albert J and Ting Wang (2009), “How do designated market makers create value for small-caps?” AFA 2008 New Orleans Meetings Paper.
Weill, Pierre-Olivier (2007), “Leaning against the wind” Review of Economic Studies, 74:1329-1354.