Lesson 16 Crisis Related Liquidity Provisions

The History of a Powerful Paragraphhttp://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3485 Federal Reserve Liquidity Provision During the Financial Crisis of 2007-2009, Michael Fleming, FRBNY Staff Reports # 563, July 2012. http://www.newyorkfed.org/research/staff_reports/sr563.html Interest on Reserves and Monetary Policy, Marvin Goodfriend , FRBNY Economic Policy Review 2002 http://www.newyorkfed.org/research/epr/02v08n1/0205good.pdf

When Banks Borrow From The Discount Window Bank Reserves Increase

Federal Reserve Banking System

assets liabiliies assets liabiliies +Discount Loans +Reserves +Reserves +Due to Fed

Eligible Collateral for Discount Window Advances

0-5 >5-10 >10U.S . Treasuries & F ully G uaranteed Agencies

B ill/Notes /B onds/Inflation Indexed 99% 97% 96%Zero C oupon, S TR IP s 98% 96% 92%B ills/Notes/B onds - U.S . D ollar D enominated 98% 96% 95%Zero C oupon - U.S . D ollar D enominated 97% 95% 91%

G overnment S pons ored E nterpris esB ills/Notes/B onds 98% 96% 95%

C orporate B ondsA AA rated - U.S . D ollar D enominated 97% 95% 94%B B B -AA rated - U.S . D ollar D enominated 95% 93% 92%

Municipal B ondsU.S . D ollar D enominated 98% 96% 95%

As set B acked S ecuritiesA AA rated 98% 95% 83%B B B -AA rated 89% 86% 82%

C ollateralized D ebt Obligations - AAA rated 92% 91% 90%C ommercial Mortgage B acked S ecurities - AA A rated 97% 93% 92%Agency B acked Mortgages

P ass Throughs 98% 96% 95%C MOs 98% 96% 90%

C ommercial L oans & L eas esMinimal R is k R ated7 87% to 96% 87%

Normal R isk R ated8 63% to 95% 63%C ommercial R eal E state L oans

Minimal R is k R ated7 78% to 96% 78%

Normal R isk R ated8 57% to 95% 57%C ons umer L oans - Uns ecured 60% to 96% 60%C ons umer L oans & L eas es (auto, boat, etc.) 76% to 96% 76%C ons umer L oans - C redit C ard R eceivables 59%C ons umer L oans - S ubprime C redit C ard R eceivables 54%S tudent L oans 83%

C ollateral C ateg ory 2

Marg ins for S ec urities (as percentage of

es timated fair market value)3

Marg ins for L oans(as percentage of estimated fair market value)

Duration B uc kets Individually D epos ited L oans 4, 5

G roup Depos ited L oans 4

Change in Discount Rate Policy

Prior to 2003• Discount Rate was set below Fed Funds rate• The Discount rate served as anchor on the Funds rate• Banks were forced to borrowed from the discount window,

because the provision of nonborrowed reserves was below the demand for combined demand for required and excess reserves

• There were implicit costs of borrowing from the Fed, and banks were generally reluctant to do so, unless the Fed funds rate was elevated relative to the discount rate

• The larger the volume of forced discount window borrowing the great the spread between the discount rate and the Funds rate

Total Reserves and Nonborrowed Reserves

Discount Rate Policy Prior to 2003• During times of financial market stress, such as the

failure of Continental Illinois in 1984 the implicit costs of borrowing from the Fed became more pronounced.

• The higher the implicit costs the larger the spread between the Funds rate and the discount rate for a given level of borrowing.

• The FOMC would establish “Borrowing Objectives”, instructing the Open Market Desk to provide nonborrowed reserves in such volumes as to force a particular volume of discount window borrowings

• In effect the FOMC was attempting to foster a particular spread between the funds rate and the discount rate

The higher the level of Net Borrowed Reserves (borrowed reserves – excess reserves), the higher the Funds Rate trades above the Discount Rate

Beginning January 2003 The Discount rate became a penalty rate

• The discount rate was set initially 1 percent above the prevailing Fed funds target

• By having a penalty rate the Fed attempted to remove any implicit costs of borrowing.

• Banks were no longer discouraged from borrowing at the discount window

• This new approach to discount window policy was thought of as putting a ceiling on the Fed funds rate

In 2003 the Fed change the way the discount window operates. Henceforth, the discount rate was set as a spread above the FF target…On August 17, 2007 that spread was reduced from 1% to only ½%, and on March 16, 2008 the spread was reduced to only ¼%.

Cutting the discount rate usually doesn’t impact on the funds rate, only if banks are already borrowing heavily from the window

Onset of Current Crisis: Term Funding Rates (1-mo Euro$) exceeded the discount rate early in the crisis

Crisis Related Adjustments to Discount Window Policies

• The Fed’s first crisis related action was to reduce the spread between the funds rate target and the discount rate from 1% to .50%. This resulted in a drop in the discount rate from 6-1/4% to 5-3/4%.

• Later following the the unwinding of Bear Stearns in March 2008 the discount rate spread was reduced to only .25%.

• Initially the Fed also extended the term of borrowings from overnight to up to 30-days, after Bear Stearns this was increased to 90-days.

• The intent was to encourage borrowings so that stress in the inter-bank funding markets would ease

• Banks still would not go to window because of a perceived stigma

Why a Stigma in borrowing at the discount window?

• Banks were concerned that if it became known that they were accessing the discount window they would be perceived as suffering liquidity problems

• Banks feared depositors might withdraw deposits• Banks feared that other creditors, such as banks

lending Fed funds, would pull back credit• Banks also feared that speculators would “short”

their stock, causing a rumor related plunge in their stock price.

Why was the Fed concerned about the lack of borrowing?

• The Fed was hoping that the stress in the term interbank funding market would encourage discount window advances, recall the purpose of setting the discount rate above the funds rate was to provide a ceiling on the funds rate, and related interbank financing costs. If banks borrowed from the window the stress in the markets would be relieved.

What Did the Fed Do to Increase Liquidity of Financial Institutions?

• Eased Terms at Discount Window – Lower Discount/FFR Target Spread, Longer Borrowing Terms

• Term Auction Facility (TAF)—Instead of banks coming to the window, the Fed auctioned credit. Banks bidding successfully in the auction won credit at costs below market term funding rates

• Fed opened the Primary Dealer Credit Facility (PDCF) to ensure liquidity to dealers with appropriate collateral

• Fed activated Currency Swap Lines providing dollar related credit to foreign central banks to enable a re-lending of these dollars to banks outside the US

Crisis Related Liquidity Provision by the Fed

Under Section 13(3) of the Federal Reserve Act the Fed provided credit to systemically important institutions such as AIG

The Various Liquidity Programs Enacted During the 2008/2009 Period Caused Bank Reserves to Rise

The Rise in Bank Reserves Associated with these Liquidity Provisions would have resulted in a Fed funds rate plunge to zero, if not for payment of interest on reserves

By paying Interest on Reserves (IOR) the Fed could expand its balance sheet without having the funds rate fall to zero. The thinking was that IOR would put a floor on the funds rate, even when there was an abundance of excess reserves in the banking system.

Fed Pays 0.25% Interest on Reserve Balances, lifts floor on funds from zero to 0.25%

Why Does the Funds Rate Trade Below the Floor? Answer: Not all deposits at Fed pay interest. GSEs don’t earn interest on deposits and therefore have incentive to sell these deposits (reserves).

Fed will move towards managing the Fed funds rate within Fed will move towards managing the Fed funds rate within a “corridor” sometime in the years aheada “corridor” sometime in the years ahead

The demand curve has a downward-sloping portion because banks want to The demand curve has a downward-sloping portion because banks want to hold more reserves when the federal funds rate is lowerhold more reserves when the federal funds rate is lower

The Supply Curve for Bank Reserves: Discount Rate The Supply Curve for Bank Reserves: Discount Rate serves as a theoretical ceiling on the funds rateserves as a theoretical ceiling on the funds rate

The supply of reserves is vertical when The supply of reserves is vertical when ffrffr is less than the is less than the primary discount rate and horizontal when they are equal primary discount rate and horizontal when they are equal

The IOER serves as a theoretical floor on the funds rateThe IOER serves as a theoretical floor on the funds rate

When When ffrffr exceeds the Fed’s target, the Fed engages in purchases in the amount exceeds the Fed’s target, the Fed engages in purchases in the amount of of ∆R and equilibrium ∆R and equilibrium ffrffr will equal the target will equal the target

Together the IOER and the Discount Rate define a Together the IOER and the Discount Rate define a “corridor” for the Fed Funds Rate“corridor” for the Fed Funds Rate

When When ffrffr exceeds the Fed’s target, the Fed engages in purchases in the amount exceeds the Fed’s target, the Fed engages in purchases in the amount of of ∆R and equilibrium ∆R and equilibrium ffrffr will equal the target will equal the target

A Shift in the demand for reserves does not A Shift in the demand for reserves does not cause the funds rate to trade above ceilingcause the funds rate to trade above ceiling

If demand for reserves is DIf demand for reserves is D22 instead of D instead of D11, , ffrffr will rise to equal will rise to equal the discount ratethe discount rate