The expanding role of the central bank comments on Thomas Baxter’s paper

by Professor Rosa M. Lastra Centre for Commercial Law Studies, queen mary university of london

19 January 2009

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Some contributions of Tom Baxter’s paper

The importance of a clear mandate and a set of enabling rules for the central bank with regard to financial stability, in particular with regard to its LOLR.

The imaginative use of central bank powers, in particular the clever interpretation of Section 13(3) of the Federal Reserve Act and the creation of SPVs to inject liquidity to a wider range of institutions and markets in response to the evolving and expanding crisis.

The Fed will continue to expand its balance sheet and to do ‘whatever it takes, within the bounds of the law to deal with this financial crisis’ (in line with Bernanke’s talk at the LSE last week).

The Fed has devised ways to mitigate ‘stigma’ (which ‘results from a perception that only the desperate go to the LOLR’).

The literature on systemic risk and contagion ought to be rewritten. When confidence is fragile, the perception that a financial institution (not just a commercial bank) is in trouble, becomes a self-fulfilling prophecy.

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Classic principles of LOLR

The name “lender of last resort” owes its origins to Sir Francis Barings, who in 1797 referred to the Bank of England as the “dernier resort” from which all banks could obtain liquidity in times of crises.

The lender of last resort (LOLR) doctrine is based upon four principles (not legal principles), which were first elaborated by Henry Thornton in 1802 and Walter Bagehot in 1873:

1. The central bank should prevent temporarily illiquid but solvent banks from failing, by providing short-term loans.

2. The central bank should lend freely (i.e., in an “unlimited” fashion), but charge a penalty rate (a higher rate of interest).

3. The lending should be collateralized (good collateral valued at pre-panic prices).

4. The central bank should make its readiness to lend freely clear in advance.

Two other operating principles often apply: first, the central bank's LOLR role is discretionary, not mandatory; second, the central bank assesses not only whether the situation is of illiquidity or insolvency, but also whether the failure of an institution can trigger by contagion the failure of other institutions. Bagehot and Thornton contended that the LOLR's responsibility is to the market, to the entire financial system and not to specific institutions.

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Market liquidity & individual assistance

There are two main types of crisis situations where the provision of emergency liquidity assistance could be critical. The first is the case of a general liquidity dry up (of which

we have ample examples in 2008) leading to a widespread and generalised questioning of the liquidity of different sorts of financial institutions. OMOs

The second, the classic case of LOLR assistance (Thornton and Bagehot), refers to collateralized lines of credit to illiquid, but not necessarily insolvent institutions.

A particular crisis situation can arise when one or more financial institutions get into trouble due to problems which originate in the payment system that can lead to a payment system gridlock.

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Revisiting LOLR (a moving target)

Lending to insolvent institutions is a departure from the classical LOLR principles. The risk of loss to the central bank is ultimately a risk of loss to the public (taxpayers). In the EU there is also a need to comply with state aid rules. Difficulties in valuation of various assets presents at the moment a serious information problem; concerns about liquidity can be uncertainty about insolvency.

Lending over an extended period of time (which is often an indication that the problems are not of mere illiquidity) increases the risk of loss to the central bank, risk of loss to the public. Any extended lending – committing taxpayers’ money – should require the approval of the fiscal authority.

Punitive rate? (lender of primary or only resort…) Collateral policy (broadening range of assets and different approaches over the

last months by ECB, Bank of England, Fed). Importance of credibility Banks and other institutions (broadening range of institutions; e.g., Fed) Assistance to foreign institutions? Legal framework Stigma (Northern Rock and others); overt and covert assitance The central bank should not use its LOLR to bail out bank owners; the LOLR’s

ultimate responsibility remains to the market, to the entire financial sector and not to any particular inst.

PAPER WITH ANDY CAMPBELL

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Why is LOLR/ELA a unique crisis

management instrument? It is the immediacy of the availability of central bank

credit (the central bank being the ultimate supplier of high-powered money) that makes the LOLR particularly suitable to confront emergency situations.

This ‘immediacy’ contrasts with the ‘time framework’ of other crisis management instruments. Insolvency proceedings by definition are lengthy and subject to legal constraints.

It is an instrument that affects monetary and financial stability

When the inter-bank market dries out, the central bank becomes the lender of only resort.

Reputation and confidence

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Protection and regulation

Governments often claim that if they are to assist an institution in “a rainy day” they should regulate that institution in “a sunny day.” Hence, regulation and protection tend to be mutually reinforcing.

The downside of “protection” is moral hazard. In the absence of protection, individuals and institutions tend to be more conservative and less risk prone. Golden rule: if you give the gold, you give the rules…

Public opinion is usually sympathetic towards regulation in the aftermath of crises.

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Ambiguity?

According to some commentators a degree of ‘constructive ambiguity’ is desirable in the case of LOLR and crisis management. Ambiguity and uncertainty as to the procedures and loci of power are not constructive. In the event of a crisis, the procedures to follow should be crystal clear ex ante for the institution affected, other market participants and the public at large. This affects not just LOLR but other crisis management instruments.

The only ‘ambiguity’ that can be constructive in LOLR is the discretionary component in the provision of such assistance, in the sense that there is no obligation for the central bank to provide LOLR loans. It is this discretionary nature that reduces the moral hazard incentives inherent in any support operation.

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Discretionary powers

The central bank, before exercising its discretion to act or not to act as LOLR, should conduct a cost-benefit analysis of the results of its intervention (this is of course a difficult exercise, since it is done under pressure and with the need to reach a decision as promptly as possible) . The costs are typically the risk of loss to the central bank and the creation of moral hazard incentives. The benefits accrue from the speed, flexibility and decisiveness with which the central bank can cope with an emergency crisis. In this cost-benefit analysis due consideration should be given to the interests of depositors, other creditors, shareholders and taxpayers.

A generalized banking crisis is different from an individual banking crisis in a healthy economy, an important element that the central bank will also consider.

The central bank should be held accountable for the use of its discretionary LOLR powers. Such accountability needs to be articulated carefully, particularly in cases where the central bank has no direct role in bank supervision; due consideration should also be given to the degree of central bank independence from the Treasury or Minister of Finance with regard to the exercise of the LOLR function.

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Regular DWL and OMOs For Depositary Institutions (DIs)- August 1997 – the Term Discount Window Program DIs - December 1997 - the Term Auction Facility (TAF) – broader range of counterparties and broader range of

collateral Beyond DIs - Section 13.3 of the Federal Reserve Act

11 March 2008 - Term Securities Lending Facility (TSLF) – lending Treasury securities to primary dealers taking in exchange mortgage backed securities (MBS). (A security swap does not increase the money supply). TSLF is similar to the Special Liquidity Scheme adopted in the UK, with swaps of MBS for gilts, though with a longer time duration in the case of SLS of one year up to three years (TSLF-28 days)

14 March 2008 - The rescue of Bear Stearns (conduit loan made by the Fed to JPMorgan Chase, which in turned lent to Bear) marked the first time since the 1930s that the Fed used the authority under section 13.3 of the Federal Reserve Act (the authority was invoked but not used in the 1960s) to lend to financial institutions other than a regulated DI because of “unusual and exigent circumstances”. Bear Stearns was too interconnected to be allowed to fail at a moment when markets were extremely fragile. The Fed assisted in the takeover of Bear by JPMC (16 March 2008). Change in share price from $2 to $10/share. In June, an SPV (Maiden Lane I) was created by the Fed to hold assets acquired to facilitate the merger of JPMC and Bear. ‘Marriage’ of 13.3 and SPV: with proper Section 13.3 authorization, the Fed can create a limited liability company ad lend to it, in order to add liquidity or effect some other policy objective.

16 March 2008 - The Fed developed the primary dealer credit facility (PDFC), hardly used until Lehman Bros’ bankruptcy on September 15. Under PDFC, the primary dealers would pledge securities to borrow dollars (not securities, the objective ot the TLSF).

In September 2008 the Fed extended liquidity assistance to insurance companies (AIG) forming two SPVs to which it lent funds to help stabilize AIG. Then assistance was also offered to mutual funds.

In October 2008, the Fed opened the commercial paper funding facility, in which the SPV buys commercial paper using the proceeds of a Fed loan.

In November 2008 the Fed opened the Money Market Investors Funding Facility The Fed announced on 25 Nov 2008 the Term Asset-Backed Securities Lending Facility with a longer

duration than any previous facility: at least one year and available to all US Persons

Actions by the Fed (Tom’s paper and http://www.newyorkfed.org/markets/Forms_of_Fed_Lending.pdf)

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FDICIA Access to the discount window is governed by Section 10(a) and 10(b) of the Federal Reserve Act and

by Regulation A. The Federal Deposit Corporation Improvement Act (FDICIA) in 1991 amended sections 10(a) and 10(b) of the Federal Reserve Act, by adding a paragraph on “Limitations on Advances” which states that “no advances to any undercapitalised institution by any Federal Reserve bank … may be outstanding for more than 60 days in any 120 period,” unless “the head of the appropriate Federal banking agency certifies in advance in writing to the Federal Reserve bank that any depository institution is viable; or the Board [of Governors] conducts an examination of any depository institution and the Chairman of the Board certifies in writing to the Federal Reserve bank that the institution is viable.” The meaning of this provision is clear: LOLR loans are by nature short term loans to illiquid but solvent institutions. Any extended lending is an indication of insolvency rather than of mere illiquidity and any delay in closing an insolvent institution increases the cost to the insurance fund, thus shifting the risk from depositors to taxpayers. LOLR loans to insolvent institutions are in effect a partial substitute for deposit insurance. FDICIA’s amendment to section 10(b) of the Federal Reserve Act also stresses the discretionary nature of the LOLR: “A Federal Reserve bank shall have no obligation to make, increase, renew, or extend any advance or discount under this Act to any depository institution.” Such a discretionary component is an important safeguard against moral hazard incentives.

FDICIA requires the resolution of bank failures on a ‘least cost basis’ to the insurance fund, unless it threatens to trigger a payment system breakdown or serious adverse effects on economic conditions or financial stability (systemic risk exception, Section 141 FDICIA) in which case FDIC and Fed may recommend a more costly solution (FDICIA, 12 USC 1823 (c)(4).

FDICIA links the intensity of supervision to the level of capitalisation and thus reserves especially severe treatment for critically undercapitalised depository institutions as opposed to depository institutions that are merely undercapitalised: “Federal Reserve banks may have outstanding advances to such institutions only during the 5-day period beginning on the date the institution became critically undercapitalised or after consultations with the Board. After the end of this 5-day period, the Board [of Governors] shall be liable to the Federal Deposit Insurance Corporation for the excess loss (i.e., for the loss that exceeds the loss that the FDIC would have incurred if it had liquidated the institution as of the end of that 5-day period), without regard to the terms of advance or any collateral pledged to secure the advance.” This provision tries to prevent the granting of LOLR loans to insolvent institutions by shifting the financial burden of keeping alive insolvent institutions from the FDIC to the Fed.

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What next?

“At the end of the tunnel of a financial crisis lies not light, but the gloom of recession. As surely as smoke follows fire, what comes after a financial meltdown is an economic downturn”. Aditya Chakraborty, The Guardian, 15 October 2008

From monetary stability to Financial Stability“History demonstrates conclusively that a modern economy

cannot grow if its financial system is not operating effectively”. Bernanke, LSE talk, Jan 2009.

Regulatory reform (in the US and elsewhere).With regard to the US case, the expanding role of the Fed

and the diminishing role and reputation of SECReshaping the financial industry (investment banking; bonus

and compensation schemes; unregulated pockets of financial activity,risk management; universal banking and financial conglomerates- Citigroup’s split)