Crisis and Response: Central Banks and the Financial Crisis Stephen Cecchetti*Economic Adviser and Head, Monetary and Economic Department Bank for International Settlements* Views expressed are those of the author and not necessarily those of the BIS
Outline • Prelude to a Crisis • Central Bank Tools • The Crisis Hits • Policy Response
Ratio of Home Prices to Rents Source: Ratio of Federal Reserve Board flow of funds value of residential real estate, Table B. 100 line 4 to Bureau of Economic Analysis national income and product accounts housing service consumption, table 2.3.5 line 14.
US Mortgage Market • Increase in leverage • Increase in securitization • Shift away from Traditional lending Note: GSE is “Government Sponsored Enterprise” and refers primarily to Fannie Mae and Freddie Mac.
A Few Details • Subprime ABS • Often financed by commercial paper (SIVs) • Banks provided back up lines of credit • So long as house prices rise • Refinancing is straightforward • Estimation of default rates is unimportant
Prelude to the Crisis • Home prices at unprecedented levels • Home owners had substantial leverage • Mortgage quality had declined • Asset-backed Securitization had spread • Created opaque instruments used as collateral
The Central Bank Toolbox • Balance Sheet • Traditional Monetary Policy Tools
Balance Sheet Management • Control the size • Control asset composition
Traditional Monetary Policy Tool Box • Overnight/Short-term Interest Rate • Lending and Deposit Facility Rate
The Crisis Hits • Thursday August 9, 2007 • ECB injected €94.8 billion overnight • Fed injected $24 billion overnight • Reserves supplied in response to bank demand • Symptoms • LIBOR • Commercial Paper
Spread between 3-month LIBOR and 3-month Expected Federal Funds rate July 2007 to Present, daily
The Crisis Hits • Risk premia increased • Increased reliance on bank financing • Difficult to value assets could not be used as collateral
The Crisis • House prices decline • Default rates become difficult to estimate • Value of MBS and CDO becomes impossible to compute • Sub-prime collateral unacceptable • Banks • Lines of credit are drawn down • Loss in asset value reduces capital • Uncertainty about future write downs • Balance sheet capacity falls • Lenders • Face Increased Risk • Liquidity: Don’t know own capacity • Credit: Counterparty ability to repay • Capital Impairment • Reduce Lending • Raise Capital
Two Types of Liquidity • Market Liquidity: Asset SpecificAbility to sell without moving price • Funding Liquidity: Institution Specific Ability of solvent institution to borrow
Market Volatility Asset Sales Drive Prices Risk-based Capital & Margin Market Liquidity Funding Liquidity Financial Institution Leverage Liquidity Spirals: Modern Bank Runs
Two types of actions • Balance sheet size: Fed funds target • Asset composition: Influence spreads
Unconventional Federal Policy actions (cont.) • Pricing: Discount Rate • Method: Auctions • Term: Longer-term loans and repos • Swaps: Dollars to banks based outside the US • Securities Lending: US Treasurys for ABS • Counterparties: Primary Dealers, Money Market Funds • New Legal Entities: Maiden Lane LLC • Market making: Commercial Paper
Contrast with the ECB • Eurosystem assets are largely repo • Regular Open Market Operations: • Up to 1700 counterparties (US has 19) • Broad collateral (US only Treasury & Agency) • European banks willing to borrow • Investment & commercial banks combined. • No need to • Reduce maturity of portfolio • Broaden collateral • Widen access
Summary: • Boom and bust in price of leveraged assets • Change in financing patterns • Opaque & difficult to value instruments • Lack of transparency exacerbated principal-agent problem • Decline in asset prices led to liquidity spiral • Market illiquidity • Funding illiquidity
Do Central Bankers Have the Tools? • Crisis management: Asset Composition • Sphere of influence: To whom do you lend? • Credit Risk: What do you accept as collateral? • Asset Holdings: What do you buy? • Crisis prevention: Traditional Tools • Regulation and Supervision • Lean against booms in prices of leverage asset
Do Central Bankers Have the Tools? • Short-run: Yes • Emergency liquidity assistance buys time. • Financial Institutions must either • Reduce size of balance sheet (de-leverage) • Raise Capital
Do Central Bankers Have the Tools? • Short-run: Yes • Emergency liquidity assistance buys time. • Financial Institutions must either • Reduce size of balance sheet (de-leverage) • Raise Capital • Long-run: No • Cannot de-leverage by borrowing! • Fiscal policy needs to step in.
Broader Lessons • Need for Data on balance sheets and quantities • Role of Deposit Insurance • Organization of regulation & supervisions • Standardisation and trading in organized markets