Archive for September 18th, 2008

Lender of Last Resort logic for emerging or developed?

September 18, 2008

I have always followed Frederic Mishkin’s work religiously. His work on financial markets and monetary policy has been simple exemplary. His writing has always been very simple and lucid and this made all his papers very easy to read and understand.

Looking at the recent crisis, I just recalled a speech given by Mishkin in 2007 on lender of last resort (LOLR) function of central banks. (A large part of the speech is based on this paper presented at Kansas City Fed Symposium in 1997. The theme in 1997 – “Maintaining Financial Stability in a Global Economy” was very similar to the recent 2008 symposium –  “Maintaining Stability in a Changing Financial System” )

Mishkin says:

To be clear, by lender of last resort, I mean short-term lending on good collateral to sound institutions, when financial markets temporarily seize up. I do not mean rescuing financial market participants from the consequences of their bad decisions by lending to unsound institutions with little capital, thereby postponing the recognition of insolvency.

Despite the need for a lender of last resort, central banks in emerging-market countries, unlike those in advanced countries, often cannot undertake this role.

First, emerging-market economies often have much of their debt denominated in foreign currency.

Second, the credibility of central banks in these countries to keep inflation under control is low.

Accordingly, an injection of liquidity in the form of domestic currency can actually make the financial crisis worse by raising inflation fears and thus causing the domestic currency to depreciate. Given a debt structure characterized by liabilities denominated in foreign currency, this depreciation causes the domestic-currency value of the liabilities to rise, induces a deterioration of balance sheets, and thus causes a severe economic contraction. Moreover, a run on the domestic currency will likely be associated with a spike in nominal domestic-currency interest rates–just the opposite of what the injection of liquidity was intended to achieve .

So what should emerging markets central banks do?

Therefore, if liquidity is to be provided during a financial crisis in an emerging-market economy, it generally should be in the form of foreign, not domestic currency. But, if a domestic central bank lacks the foreign reserves to conduct emergency liquidity assistance in foreign currency to stop a financial crisis or promote a recovery when one occurs, can another institution come to the rescue? The answer is yes, and it is often best if the assistance comes not from within the country, but from without. Liquidity provided by foreign sources can help emerging-market countries cope with financial crises without many of the undesirable consequences that can result from the provision of domestic-currency.

This was 2007 and how things have changed dramatically. Infact the entire idea has been turned on its head.

It is central banks of developed economies that have to provide liquidity (or do the lender of last resort) in foreign currency mainly in US dollar. The emerging markets so far have been doing quite fine. Moreover, central banks of developed economies have expanded their accepted collateral basket to securities issued by US Treasury (Bills,  bonds etc) .

The recent press releases from various central banks is just another extension of this LOLR function started in 2007.

The FOMC has authorized increases in the existing swap lines with the ECB and the Swiss National Bank. These larger facilities will now support the provision of U.S. dollar liquidity in amounts of up to $110 billion by the ECB, an increase of $55 billion, and up to $27 billion by the Swiss National Bank, an increase of $15 billion. 

In addition, new swap facilities have been authorized with the Bank of Japan, the Bank of England, and the Bank of Canada. These facilities will support the provision of U.S. dollar liquidity in amounts of up to $60 billion by the Bank of Japan, $40 billion by the Bank of England, and $10 billion by the Bank of Canada.  

All of these reciprocal currency arrangements have been authorized through January 30, 2009. 

Mishkin a leading votary of financial globalisation just missed how integrated the markets have become.  A stress in one country has an impact on the other as well. LOLR in foreign currency is also applicable to countries which are more financially integrated as others.

Prof. Mishkin should perhaps try and rework his thoughts/papers in line with this new reality.

Federal Reserve is broke now

September 18, 2008

With all the bailouts, one was always wondering what happens to Fed. How does it get the cash etc to bail out so many firms? Moreover, with Fed now accepting almost everything as collateral one was always going to question Fed’s balance sheet.   

Now it seems Fed has also run out of cash. FT Alphaville points (hat tip Eurointelligence) that US Treasury has taken out a special liquidity scheme to help Fed. The statement from US Treasury says:

The Federal Reserve has announced a series of lending and liquidity initiatives during the past several quarters intended to address heightened liquidity pressures in the financial market, including enhancing its liquidity facilities this week.  To manage the balance sheet impact of these efforts, the Federal Reserve has taken a number of actions, including redeeming and selling securities from the System Open Market Account portfolio.

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve.  The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program, which will provide cash for use in the Federal Reserve initiatives.

I was thinking how will this help? On one hand Fed is providing liquidity and on the other Fed is draining that liquidity via the T-Bill auctions.

I also read New York Fed statement which says the same thing:

Today, the Treasury Department announced the initiation of a temporary Supplementary Financing Program. The program will consist of a series of Treasury bill auctions, separate from Treasury’s current borrowing program, with the proceeds from these auctions to be maintained in an account at the Federal Reserve Bank of New York. Funds in this account serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.

This is pretty scary. I dont know what is going to happen ahead. There is news that Morgan Stanley (only 2 i-banks remain – Goldman Sachs and Morgan) also might be taken over by Wachovia or Citic (a Chinese Bank).

Funny times really. I r’ber reading when Chinese started oenoing up their financial sector in 2006, Morgan Stanley was one of the leading firms to help Chinese firms become more market oriented. Not in their wildest dreams would MS have imagined that they would need help from China.

Assorted Links

September 18, 2008

1. WSJ Blog asks whether we can get some reforms going in US fin regulation

2. TTR on AIG.

3. MR points central bank independence lost. WSJ Blog points central banks on soccer field

4. Krugman points liquidity trap situation in US

5. IDB on double standards in development sector

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