Transcript Slide 1

Two Cheers for Bagehot
John C. Williams
Federal Reserve Bank of San Francisco
Reserve Bank of India First International Research Conference 2010
“Challenges to Central Banking in the Context of Financial Crisis”
February 12-13, 2010
The views expressed in this paper are solely those of the author and should not be
interpreted as reflecting the views of the management of the Federal Reserve Bank of
San Francisco or the Board of Governors of the Federal Reserve System.
Bagehot’s Dictum
• To forestall panics, Bagehot said the central bank
should lend freely under three conditions:
– Solvent borrowers
– Good collateral
– High interest rate
• Principle not limited to banks
– Any solvent borrower with illiquid assets and shortterm funding needs
Bagehot and the Fed
• In the United States, depository institutions have
access to discount window:
– Soundness test
– Collateral with haircut
– Penalty rate over fed funds target
• In “unusual and exigent circumstances” Fed can
lend to other entities. This “13(3)” clause was
invoked several times during the crisis.
• Lending programs exceeded $1.5 trillion in
December 2008, has since declined dramatically.
Fed Liquidity Programs
Limits to Bagehot: Stigma
• Starting in summer of 2007, “Libor” rates on one-month
and longer interbank loans rose.
• Banks shunned discount window, in part because of stigma
associated with such borrowing:
– penalty rate
– perception that Fed prefers banks use markets for liquidity
• Term auction facility (TAF) introduced in December 2007
with goal of reducing stigma and increasing willingness to
borrow (also, no penalty rate if auction undersubscribed).
• Swaps with several foreign central banks introduced to ease
stress in U.S. dollar interbank markets abroad.
Black Swan in the Money Market
TAF
announced
Limits to Bagehot: Counterparty Risk
• Despite availability of discount window, Term Auction
Facility, and foreign central bank swaps, term interbank
rates remained elevated due to counterparty risk.
• Liquidity policies alone cannot solve solvency
problems.
• Conditions improved in money market only after new
government guarantees on bank debt and deposits,
infusions of capital into banking system, and
uncertainty about situation ebbed.
Limits to Bagehot: Solvency
Bagehot for the 21st Century
• Crisis showed that key short-term funding
markets are susceptible to panics and runs
similar to banks
– Investment banks (Repurchase agreements)
– Commercial paper funded by money market
mutual funds
– Asset-backed Securitization
• In 2008, Fed instituted discount window
lending programs to these markets
Extending Access to Capital Markets
CPFF and MMIFF
introduced
Extending Access to Securitization Markets
Limits to Bagehot: Collateral
• In capital market applications, good collateral
condition severely restricts scope of programs
– CPFF limited to highest quality commercial paper
– Limited TALF’s use for real estate MBS
• With TALF, Treasury took risk position ahead of
Fed, increasing size and scope of program.
Conclusion
• Two “cheers” for Bagehot:
– Presence of lender of last resort critical to
stemming panic in banking.
– Extension to segments of capital markets used for
short-term funding is an important innovation
that proved effective during crisis.
Why Only Two “Cheers” ?
• Limits to Bagehot
– Stigma
– Solvency vs. liquidity
– Collateral requirement can be restrictive in crisis.
• Risks
– Default risk (more than simple liquidity provision).
– Central bank unavoidably picks “winners” and “losers” in
choosing market segments to lend to.
– Blurs distinction from fiscal policy, potentially undermining
central bank independence.
Critical Issues
• Moral hazard
• Non-bank financial institutions and markets now expect to
have access to discount window in crisis.
• Insufficient liquidity management
• Systemic Risk Supervision
– Reduce contagion
– Orderly resolution of systemically-important financial
institutions
– Non-central bank support for systemically-important FI and
markets.
Choosing Who Has Access
U.S. Private-Label RMBS and CMBS Issuance
Billions
of $
60
Billions
of $
60
(3-month moving average)
50
50
RMBS
(residential)
40
40
30
30
CMBS
(commercial)
20
20
10
0
Jan-03
Dec.
10
0
Nov-03
Sep-04
Jul-05
May-06
Mar-07
Jan-08
Nov-08
Sep-09
Extending Access to Investment Banks
Limits to Bagehot: Collateral
Commercial Paper Risk Spreads
Basis
points
650
Basis
points
(Spreads over 30-day AA Nonfinancial Rate)
650
600
600
550
550
A2/P2
Nonfinancial
500
500
450
450
400
400
350
350
300
300
250
250
AA Asset-Backed
200
200
150
150
100
AA Financial
2/2
100
50
50
0
0
-50
Jan-07
-50
May-07
Sep-07
Jan-08
May-08
Sep-08
Jan-09
May-09
Sep-09
Jan-10