The Challenges for Policymakers: Short-Term and Long-Term Responses

The challenges that this episode of financial market turmoil has posed for public authorities can be divided into those meriting short-term responses and those meriting long-term responses. In this section, we focus on the short-term efforts of central banks to provide liquidity and on the longer-term recommendations of the recent report of the Financial Stability Forum to the Group of Seven (G7) finance ministers and central bank governors (Financial Stability Forum 2008).

A. Short-term responses: What central banks did

The short-term responses of central banks to the unprecedented and fast-changing situation have been creative, energetic, and, in terms of the specific goal of keeping the system from grinding to a halt, effective. As Kearns and Lowe (2008) point out, market liquidity has a large public good component and a sudden loss of such liquidity is often the result of a market failure. At the same time, Davis (2008) emphasizes the moral hazard that accompanies any form of central bank emergency lending. In their efforts to restore market liquidity, central banks have clearly been seeking to strike the right balance between providing a public good and avoiding moral hazard.

With respect to operations in short-term money markets, central banks have initiated a wide variety of actions. One set of responses may be characterized as a broadening of the scope of their operations.⁵ This broadening took place along four dimensions:

• first, there was a widening of the collateral accepted, which means that central banks have taken a de facto interest in the liquidity of a wider range of asset markets;
• second, there was a widening of the set of counterparties, notably with the introduction of the Primary Dealer Credit Facility by the US Federal Reserve;
• third, central banks have done more to funnel liquidity in their own currencies to entities in other economies, through instruments such as swap agreements; and,
• finally, central banks have increased their operations at terms longer than overnight, in order to satisfy the market's increased demand for term liquidity.

A second set of responses by central banks was designed to deal with the stigma associated with borrowing from them. Perhaps the most interesting efforts have been those made by the Bank of England and the US Federal Reserve because they address issues of transparency and the appropriate pricing mechanism for liquidity support.

The Bank of England had, in past episodes, provided liquidity support to an ailing bank in secret, generally with good results. In September 2007, however, the central bank planned to depart from past practice by announcing liquidity support for Northern Rock. As Davis (2008) described the action, this plan was pre-empted by a leak to the British Broadcasting Corporation, which led to a run on the troubled bank. This was a forceful reminder of the stigma of borrowing from the Bank of England; subsequently, other banks refused to access the Bank of England's lending facilities. It remains an open issue whether the Bank of England would have been well-advised to keep to its practice of covert financing, or whether such financing would even have been feasible in the modern-day environment of more transparent financial markets.

In the case of the US Federal Reserve, banks were reluctant to make use of the discount window because of the stigma associated with borrowing from it. Various efforts to mitigate the stigma during the early phases of the crisis failed and the discount window remained inactive. For example, the Federal Reserve reduced from 100 basis points to 50 basis points the interest premium over the target federal funds rate for borrowing from the discount window and allowed banks to borrow funds for up to 30 days.⁶

What finally succeeded was an auction mechanism. The term auction facility was announced on 12 December 2007; the first auction was conducted five days later. It was a single-price auction with a pre-determined total amount of US$20 billion and a fixed, 28-day term. Officials of the US Federal Reserve were no doubt pleased when 93 banks showed up for the auction and took up the entire amount. The question this episode raises is, why did such an auction work while Bagehot's dictum to lend freely at a penalty rate, which underlies the operation of the discount window, did not? Is it because there appeared to be “safety in numbers” associated with the auction process? This may well be so. However, by relying on safety in numbers, such auctions may not ensure that liquidity goes to the institutions that need it most, as Goodhart (2004) pointed out.

One result of the central banks' liquidity operations was to change the composition of their balance sheets. As Cecchetti (2008) explained, this is conceptually different from the usual operations related to monetary policy, which change the size of the central bank's balance sheet rather than its composition. Indeed, in the case of the US Federal Reserve, the change in the composition of the balance sheet has been quite dramatic. As shown in Figure 4 [ PDF 34.2KB | 1 page ], the US Federal Reserve started out in July 2007 with a balance sheet of about US$850 billion (excluding “other” assets), with outright holdings of Treasury securities accounting for 93% of the assets shown. One year later, the size of the balance sheet had risen to only US$890 billion, but uncommitted outright holdings of securities now accounted for only 42% of the balance sheet, with the rest of the assets presumably consisting of less liquid securities obtained through the various liquidity operations. In effect, the US Federal Reserve used its balance sheet to supply the repo market with the assets that market participants now prefer; in turn, the American central bank has taken from the market those assets that were no longer desired.

Taken together, the above-mentioned liquidity operations by central banks more generally have helped to stabilize short-term money markets. Nevertheless, the short-term money markets remain plagued by wide spreads and, from time to time, volatile rates, reflecting the underlying balance-sheet problems that still need to be resolved. Moreover, in several cases, central banks will sooner or later have to decide whether these actions are temporary measures responding to unusual circumstances or whether they should retain a more permanent place in the banks' operational toolboxes.

At the same time, there are some worrying signs that policymakers may be sowing the seeds for future liquidity and credit problems and that market participants' expectations of inflation may already be on the rise as a result. Thanks to higher inflation expectations and falling or stable policy rates, global real monetary policy interest rates, which had already been at low levels for some years, have recently dropped to negative levels in many key jurisdictions. In addition, many countries, particularly emerging market economies, have been reluctant to allow their currencies to appreciate against the dollar and other major currencies, consequently continuing their massive foreign exchange intervention purchases. This combination of a rapid and very large decline in real policy interest rates in key jurisdictions and massive foreign exchange interventions by emerging markets has contributed to a large liquidity expansion at the global level.

B. Long-term responses: The Financial Stability Forum Report

None of these short-term responses by central banks will be sufficient to stabilize the financial system unless market participants can be reassured that the more fundamental issues that led to this turmoil are being addressed. In this section, we focus on the actions set out by the Financial Stability Forum (FSF) in their April 2008 report to the Group of Seven finance ministers and central bank governors. The report draws on an extensive body of work by national authorities and the main international regulatory, supervisory, and central bank bodies.

Speaking broadly, the goal of the FSF is a financial system where risks are more accurately identified and managed, perverse incentives are reduced, and build-ups of leverage pose less of a threat. There is no silver bullet that will accomplish all of these goals at once, but concerted action in a few key areas can accomplish a lot.

In the area of strengthened prudential oversight, the key steps recommended by the FSF report involve the capital and liquidity frameworks. Implementing the Basel II framework⁷ will by itself eliminate several of the perverse incentives that were created by the existing regulatory framework. The Basel Committee is also looking actively at ways to strengthen Basel II and, in particular, has proposed increasing capital charges for complex structured credit products, credit exposures in banks' trading books, and liquidity facilities provided to off-balance sheet vehicles. The committee has also issued guidance for strengthening liquidity risk management at regulated firms.

With respect to transparency, the FSF report sets out leading practices for disclosures based on a survey of large banks and securities firms, with an emphasis on exposures, such as US sub-prime products, that the marketplace considers especially risky. Supervisors in a number of countries have actively encouraged their banks to follow these practices for their 2008 mid-year accounts.

Current discussions about valuation are also important. Better disclosure means nothing if markets are not confident that the numbers are meaningful. The report makes clear that completely suspending fair-value accounting would be a mistake as such a step would do more to reduce confidence in the system than the positives that might result from any short- term relief it might bring to holders of problem assets. But there are legitimate questions regarding how to value assets when markets are illiquid. In response to concerns expressed by the FSF, the International Accounting Standards Board (IASB) has established an expert panel—drawn from financial institutions, supervisors, investors, and auditors—to assist it in developing enhanced guidance in this respect. The objective will be to reinforce sound valuation practices and transparency, not to undermine confidence in accounting standards or valuations.

Beyond the issue of valuing assets when markets are illiquid, it is evident that, at least in the short term, asset prices tend to be driven by changes in investors' risk appetites rather than by what may be characterized as fundamentals. For example, Amato and Remolona (2005) show that CDS spreads are largely accounted for not by any measure of default risk, but rather by what can only be described as the general appetite for risk. This phenomenon calls into question the value of marking to market on a daily basis when, at this horizon, risk appetites rather than fundamentals drive market prices. Nonetheless, in the absence of reliable alternative measures of fundamental inputs such as correlation or expected volatility, market values are likely to be the most consistent, if imperfect, way to generate useful asset valuations. The challenge then becomes how to make effective use of the information market values contain without ignoring their limitations as guides to fundamental values.

This brings us to the issue of the role and use of credit ratings. Credit ratings clearly play an important role in financial markets by helping investors to filter information critical to their portfolio decisions. But the crisis revealed shortcomings regarding how the ratings are generated and how investors use ratings. The FSF has called on the rating agencies to:

• improve the quality of the rating process, including by better managing conflicts of interest in line with the revised International Organization of Securities Commissions (IOSCO) Code of Conduct (International Organisation of Securities Commissions 2008);
• differentiate ratings on structured finance from those on bonds, as a signal of the critical differences in their risk characteristics under stress; and,
• enhance the information they provide on the risk characteristics of structured products.

Others also have a role to play in improving the use of credit ratings. Investors need to better exercise due diligence and use their own independent judgment of risks, while regulators have begun to investigate the ways in which ratings are sometimes “hard-wired” into regulatory and supervisory frameworks.

Finally, the FSF has outlined a number of ways in which public authorities, at both the national and international levels, need to do a better job in assessing and responding to risks. In particular, public authorities need to:

• better translate risk analysis into action by upgrading their expertise and communicating more directly with the management and boards of regulated institutions about the risks they see;
• improve information exchange and cooperation—for example, through broader use of supervisory colleges for banks that are active in several national markets;
• enhance the effectiveness of international bodies, such as those that meet under the auspices of the BIS, by improving prioritization and conducting joint strategic reviews; and,
• clarify and strengthen national and cross-border arrangements for managing crises and dealing with weak banks.

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