Should central banks become market makers of last resort?

What is happening?

The wild market volatility in March/April 2020, unleashed by government measures to cushion the impact of Covid-19, revealed fragilities in the financial system, particularly with non-bank financial institutions, which hold around half of the world’s financial assets. The subsequent dash for cash left many gasping for liquidity. 

Many open-ended funds vested in illiquid assets struggled to meet investor redemptions, for instance. Traditional banks, although well capitalised, were unable to fully step into the breach, requiring direct central bank intervention to stabilise markets via one-way asset purchases. 

In a speech at a Reuters event on January 7, Andrew Hauser, executive director for markets at the Bank of England (BoE), suggested that these severe market dislocations potentially call for a greater role for central banks in stabilising markets when they are going haywire. Rather than just being buyers of last resort, they could also become market makers of last resort, namely by making ‘bid and offer’ prices on certain securities when others refuse too. 

He believes this might be needed because extreme events may become more frequent, which could endanger financial stability. 

Mr Hauser explained that the idea is not new and was discussed during the 2007-9 global financial crisis (GFC), but not fully developed. Indeed, in 2010, the BoE offered two-way prices for various high-quality sterling corporate bonds to support secondary market liquidity and to stop spreads bloating. 

Why is it happening? 

At the onset of the Covid-19 crisis, crucial repo and US Treasury markets experienced liquidity type problems. 

The concern is that if such extreme market shocks become more regular, there is a chance that one of them could topple the financial system. Therefore, Mr Hauser is asking if there is a case for central banks to formally add to the tools at their disposal to target more types of crises, such as one involving the failure of the IT systems of a major market participant, for instance. 

Then there is a need to stipulate the types of securities that would qualify for such a facility, as well as its design. The most obvious securities are government bonds; however, for riskier assets, Mr Hauser explains that a strong case around monetary and financial stability would have to be made to include them. 

Politicians would probably argue that supporting the economy would be a sufficient reason to make markets in corporate bonds. The quantitative easing (QE) programmes of many central banks have already included corporate bonds and some, such as the Bank of Japan and the Swiss National Bank, have even extended to equities — though the latter’s purchases, mainly US shares, were about depressing the value of the Swiss franc. 

Also, it is asked whether this tool should be discretionary, or formalised into standing facilities so market participants understand the terms of use when markets are in turmoil?

However, Mr Hauser also pondered whether such facilities, which are basically an insurance policy, should come at a price to market participants involving possibly haircuts and so on. Shadow banks should be more stringently regulated and better capitalised, making it less likely they would need the facilities in the first place, he added.

What do the bankers say? 

Bankers would be delighted by some of Mr Hauser’s suggestions and would certainly welcome greater regulation of shadow banks, which have benefited handsomely from the tougher rules imposed on traditional banks. Also, it would reduce the risk for market-making institutions during periods of extreme market stress. 

Will it provide the incentives?  

The role of central banks is already being pushed to the limits as a result of the GFC and now the Covid crisis. Their massive QE programmes — they have already added $8tn to their balance sheets since the Covid crisis started — are now effectively bankrolling government expenditure. Markets will only tolerate this for a short emergency period. Adding market making to their remits, if not properly designed and calibrated, could have unintended consequences on the proper functioning of markets and could see more risk dumped on the public sector than is strictly necessary.