Emergency measures taken by the major central banks are widely credited for having a stabilising influence on the financial system and the economy. But there are growing concerns about the long-term impact of these measures.

The events of the financial crisis were unprecedented in the professional life of any existing central banker. They have stretched every aspect of the major monetary authorities in the US and Europe – staff and operations, policy instruments, and indeed the role and philosophy of the central banks themselves.

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Perhaps most obviously, they also stretched the balance sheets of the US Federal Reserve, European Central Bank (ECB) and Bank of England (BoE). According to BoE calculations, since September 2008 the Fed balance sheet has expanded by about 12 percentage points of US gross domestic product (GDP), the BoE’s by about 10 percentage points of UK GDP, and the ECB’s balance sheet by about eight percentage points of eurozone GDP.

During the worst market dislocation, there were massive increases in repo (collateralised) lending by the central banks. In the case of the Fed and BoE, as this direct lending subsided, it was replaced by unsterilised purchasing of financial market assets – mostly government bonds – that put liquidity into bank balance sheets indirectly. The ECB initially resisted this path, but from May 2010, for rather different reasons, it began purchasing the bonds of selected eurozone sovereigns under the Securities Markets Programme (SMP).

This new level of involvement in the financial markets raises concerns about the effectiveness of such interventions, and how central banks will be able to wind down their balance sheets. There is also an urgent need to identify how central banks can handle this expanded role without compromising their core mandate to ensure price stability.

Fighting dislocations

One of the distinguishing features of the financial crisis was the squeeze on even the most liquid markets, especially interbank lending. To respond to this threat, the three major central banks all expanded their lending facilities to banks. The normal overnight or 30-day repo terms were extended up to one year in some cases, and new types of collateral were allowed in addition to the usual government bonds. These included corporate bonds, asset-backed securities (ABSs) and commercial paper, which were increasingly being refused as collateral by commercial banks.

The widening of collateral and counterparty eligibility exposed central banks to new types of credit risk, at precisely the moment when the market itself was paralysed by its inability to analyse that risk. To offset that risk, central banks imposed significant haircuts and fees on this extraordinary lending activity. These were much higher than normal market rates, but at the time many of the assets being used as central bank collateral could no longer be financed at any price in the commercial market.

“We wanted to protect the central bank against potential losses, and all these facilities ended up being money-makers. The high fees and haircuts were also motivated by the Fed's desire that this should not be a permanent facility. Once the markets calmed down, these facilities were no longer competitive, so this was part of a natural exit strategy,” says Randall Kroszner, economics professor at the University of Chicago and a governor at the Fed from 2006 to 2009, where he chaired the committee on bank supervision and regulation.

Self-liquidating

The theory that these facilities would be self-liquidating proved correct, at least in the US and UK. This underscores the central banks’ success in stabilising the immediate crisis in financial markets, while providing themselves with an exit route. Usage of the longer-term repo facilities in the US and UK has dwindled to very low levels (see charts), as commercial funding for most types of collateral has recovered.

And risk management techniques also appear to have worked. For the BoE, this included line-by-line examination of offering documents and underlying loans on ABSs, on a scale that the commercial investors had markedly failed to employ during the boom years. In one case, it transpired that assets on a supposed UK residential mortgage-backed security (MBS) transaction offered as repo collateral actually consisted of 28% exposure to Spanish car parks.

The success of expanded repo facilities is such that Mr Kroszner believes the Fed should consider establishing permanent mechanisms as part of its general policy tools. The BoE already has, introducing the auction-based Indexed Long-Term Repo (ILTR) from June 2010. Banks bid competitively to offer wider collateral forms for BoE financing of three- or six-month tenors. One banker says central banks are even considering adding new forms of collateral such as bilateral or syndicated wholesale loan tranches.

In normal markets, the ILTR facility will be uncompetitive with commercial markets – recent auctions have not been fully covered. But at times of market stress, it will backstop financing for assets that otherwise become illiquid. The BoE is confident that this can allow a clearer separation between its monetary policy and its role in ensuring market liquidity.

Buyer of last resort

Paul Fisher, executive director for markets, Bank of England

Paul Fisher, executive director for markets, Bank of England

The ILTR should also avoid a repeat of the BoE's Special Liquidity Scheme (SLS), introduced in April 2008 to enable banks to swap ABS deals that had turned illiquid for liquid government gilts. The scheme worked in terms of countering the immediate funding squeeze, reaching £185bn ($306bn) when drawdown was closed in January 2009. But it is more complicated to unwind because it created a single long-term maturity hurdle in January 2012. The BoE needed to meet participating banks individually during 2010 to discuss strategies for taking ABSs back onto commercial bank balance sheets and refinancing them, to avoid a sudden rush for funding as January 2012 approached.

“Our message to the banks was do not wait for markets to improve – get out there, get your funding in, pay up if you need to within reason, do not wait for better pricing. They did that, and not only have they repaid most of the SLS, they have also got themselves in a good position for funding for the whole of this year,” says Paul Fisher, executive director for markets at the BoE.

The SLS was based on an asset swap, but it also underlines the general difficulty that central banks are facing where their interventions were based on asset purchasing. Commercial banks choose to unwind repo financing of their own accord as market rates improve. But the exit from asset purchasing must be undertaken by the central bank itself, and risks moving markets when the central bank switches from buyer to seller.

Different designs

The exit strategy is partly dictated by the intention and design of each asset purchase programme, and the three were very different. In the US, the focus was on stemming the decline in inflation expectations. Several members of the Federal Open Markets Committee (FOMC), including Mr Kroszner and the Fed chairman Ben Bernanke, had conducted their academic research on the 1930s Great Depression, and were keenly aware that monetary policy has little effect once outright deflation sets in. The Japanese experience in the 1990s had reinforced that fear.

Japan also informed the UK’s asset purchase facility (APF), but in a different way. The BoE noted that the Bank of Japan had rather gradually purchased Japanese government bonds primarily from commercial banks, which had taken the opportunity to deleverage but had not stepped up lending to the real economy.

By contrast, the BoE purchases were conducted at a higher tempo, and the central bank focused on longer-maturity government gilts. These are mostly held by pension and insurance funds, which were then pushed to seek better returns in other asset classes such as corporate bonds and equities. Ultimately, funds from more liquid companies may well end up back on deposit at banks so the destination is the same, but the money has first passed through the financial markets.

“That may still help banks or corporates deleverage, and we cannot force banks to lend or companies to invest. But the APF did help risk assets to rally, equities rose sharply, and it brought down corporate bond spreads from exceptionally high levels,” says Mr Fisher.

Finally, the ECB’s SMP was not ostensibly for monetary-easing purposes at all. In fact, the second round of SMP purchasing in August 2011 occurred just months after the ECB had begun raising interest rates from their record lows.

This is the reason why the ECB has sterilised its government bond purchases through fixed-term deposit auctions, to ensure that the money supply is unaltered. The SMP is targeted purely at overcoming what the ECB sees as irrational market pricing of certain eurozone sovereign bonds – Greece, Ireland and Portugal in 2010, plus Spain and Italy in 2011 – on which spreads had reached levels threatening debt sustainability.

Reputational risk

Like expanded repo collateral, asset purchasing exposes central banks to credit risk. But there is also a significant reputational risk where the monetary authority purchases government bonds. If the central bank is exposed to sovereign risk, this could cause the fiscal situation to affect the judgement of those who set interest rates.

Tobias Blattner, who joined Daiwa Capital Markets Europe as senior European economist in April 2011 after seven years at the ECB, says the decision to buy government bonds was a much more radical departure for the ECB than it was for the US Federal Reserve. Unlike the Fed, the ECB’s independence is enshrined in an international treaty, so the concerns about interaction with fiscal functions ran much deeper. And while the Fed has long held a securities portfolio as a monetary policy tool via its System Open Market Account (SOMA), the ECB had previously sought to implement its monetary policy stance purely through changes in its benchmark interest rates.

There were some possible signs of the ECB’s inexperience in the first week’s intervention in Italian government bonds in August 2011. The ECB chose not to buy Italian inflation-linked debt. The SMP purchases are based on expected market elasticity, and Italian inflation-linked debt usually enjoys good demand from local pension funds that have inflation-indexed liabilities. But on this occasion, the ECB seemed to misjudge the market, and break-even inflation (the spread between nominal and real yields) moved significantly, undermining the ECB’s commitment that its interventions should not distort markets.

In theory, the creation of a European Financial Stability Fund (EFSF) capable of intervening in primary and secondary markets, plus the fiscal adjustment programmes to be put in place in the worst-affected sovereigns, should have calmed market sentiment. In practice, more than a year after the SMP started, there were still disputes among the most highly-rated eurozone sovereigns about their support for the EFSF. And while Ireland and Portugal had adopted credible IMF programmes, Italy and Spain have only recently introduced fiscal adjustment packages.

Outer limits

There are growing concerns that the prolonged nature of the ECB’s intervention – and the slow reciprocation from the fiscal authorities – is drawing the central bank deeper into dangerous waters. BoE governor Mervyn King spoke of the ECB reaching “the outer limit of what a central bank can do” in August 2011. And seven months earlier, Bundesbank president Axel Weber had announced his resignation, citing his isolation that had resulted from his opposition to the SMP.

Dirk Schumacher, a European economist at Goldman Sachs whose doctoral thesis was examined by Mr Weber, says the original intention of the eurozone’s institutional framework was that the ECB should never be placed in a situation where its exposure to sovereign risk could cast doubt on its independence.

If the debt burden is sustainable, then periodic blow-outs in spreads are survivable. Once the immediate fiscal situation has been resolved, there will be a wider range of tolerance in which the ECB will wait and see.

Dirk Schumacher

“That means its inflation-fighting credentials might be questioned, which makes its job more difficult. But the alternative of a liquidity failure and disorderly default would have had much worse consequences. So the ECB needs to do this, but needs to be seen kicking and screaming about it so that its credibility is less damaged,” says Mr Schumacher.

In effect, one could interpret Mr Weber’s decision to sacrifice his own position as a bid to shore up the reputation of the ECB as a whole. The BoE from the start adopted institutional measures to protect its independence. The monetary authority did not buy government gilts directly, but instead extended a loan to the APF (which appears as “other assets” on its balance sheet), while the UK Treasury provided an indemnity for any mark-to-market losses on the APF portfolio.

The significance of this approach became clear in mid-2011, when eurozone politicians began talking openly about private sector burden-sharing in a 'reprofiling' of Greek sovereign debt, in which maturities would be extended to help revive debt sustainability. This opened the ECB to potential net present value losses on its SMP holdings of Greek bonds, which think-tank OpenEurope estimated at €42bn purchase value in June 2011. The ECB's president, Jean-Claude Trichet, criticised the idea of a haircut on Greek government bonds, and the ECB ultimately took a leaf from the BoE’s book, demanding a deposit of €35bn from the Greek government as an indemnity.

Eurozone sovereign crisis

Ultimately, Mr Schumacher does not believe the ECB’s anti-restructuring stance is sustainable. If investors were led to think that no eurozone sovereign would ever default on its debt, this would generate precisely the type of moral hazard that contributed to the sovereign crisis in the first place.

“If the debt burden is sustainable, then periodic blow-outs in spreads are survivable. Once the immediate fiscal situation has been resolved, there will be a wider range of tolerance in which the ECB will wait and see. Nor am I convinced by the argument that we need a common Eurobond for the eurozone to survive – we had almost common borrowing spreads before 2007, and that was what created part of the problem,” says Mr Schumacher.

In fact, it is difficult to find anyone in the market who believes that the current fiscal programme and debt maturity extensions planned in Greece are enough to restore commercial funding to the sovereign over the three-year life of the programme. Or enough, even with the EFSF, to achieve eventual debt sustainability given very ambitious fiscal targets.

That would imply that the ECB may still need to buy Greek bonds again in the future. For Italy and Spain, the problem is even more marked, because of their much larger bond markets. The ECB appears to be targeting yields of about 5% on Italian and Spanish debt, which Daiwa's Mr Blattner estimates would require intervention of about €1bn per day until markets recover their confidence. That level of purchasing would exhaust even the planned expansion to the EFSF within six months. Eurosystem officials appear to recognise the potentially open-ended nature of the SMP.

“Hopefully the EFSF will be sufficient, but it remains to be seen. We cannot guess what the markets will do, because we have a problem of markets overshooting in both directions: before the crisis they were flooding Greece with money at 10 basis points over bunds, and now they are charging a spread of 1300bps over bunds,” says Franz Nauschnigg, head of European affairs at the Austrian National Bank, which is part of the Eurosystem of eurozone central banks.

Addicted banks

The fears about eurozone sovereign debt have also prevented the ECB from unwinding its bank refinancing as rapidly as the BoE and Fed. By August 2011, long-term refinancing operations had declined to €390bn, compared with a peak of just under €720bn in June 2010, when the ECB phased out its one-year refinancing facility.

But while banks in AAA-rated sovereigns such as Germany and Austria are borrowing very little at all from the ECB, banks in Greece, Spain, Ireland and Portugal still had more than €300bn in short- and long-term refinancing outstanding in mid-2011. Commercial banks are not prepared to lend directly to each other due to fears about how much sovereign exposure each bank holds. Interestingly, Italy is less affected as household leverage remains very low, so Italian banks can still draw on substantial household savings.

Carlo Mareels, senior banks credit analyst at RBC Capital Markets in London, sees evidence that Portuguese banks have even increased their exposure to the sovereign, to maintain net interest margins in the context of higher funding costs and weak private sector activity. Access to the ECB’s refinancing facility may encourage this behaviour, because the ECB has maintained Greek and Portuguese sovereign paper as eligible collateral even though the sovereigns are now below investment grade.

“Is this a healthy dynamic? No, at the moment there is a vicious cycle. Banks in the periphery are being punished by the market for holding the paper of their sovereigns, but on the other hand they are required to hold sovereign paper for liquidity purposes,” says Mr Mareels.

Fragile sentiment

The ECB has already indicated that it will hold bonds purchased under the SMP to maturity. But in the US and UK, where fresh asset purchases have so far halted, the timing for any sale of central bank holdings is unclear, amid growing signs that uncertainty over fiscal policy in the eurozone and US is undermining economic recovery.

Eurosystem monetary policy assets

This means that, while the BoE and Fed have created the monetary conditions conducive to renewed lending and investment, credit growth is sluggish. The University of Chicago's Mr Kroszner feels that, as inflation expectations return toward their long-term range, the economic benefits of quantitative easing (QE) may diminish.

US Federal Reserve credit easing policy tools
Bank of England balance sheet assets

Instead, there seems to be substantial appetite for commodities and emerging market assets, prompting concerns about new financial bubbles forming and the effect of high commodity prices on economic growth. Vincent Reinhart, a director at the Fed’s division of monetary affairs until 2007, testified to the US Congress on this problem in May 2011. He told representatives that “on net, it is likely that the economy-wide effects of the energy shock are unpleasant but not derailing to expansion. But this is a gamble, and one Fed officials must apparently have accepted when they decided to launch QE.”

A further problem is that, if financial market sentiment has become dependent on the Fed’s large holdings of government bonds, any policy statement about winding down that portfolio could cause shockwaves if mishandled.

“The FOMC members have already had one or two shots at planning exits that have had to be put on hold. They will have learnt from the Japanese example that it is not a good idea to be signalling exit before you are really ready to do it,” says one former senior trader for the Fed’s SOMA.

Any process would have to be very gradual, perhaps beginning with a decision to stop reinvesting repayments on maturing bond holdings before moving to outright sales. But Robert McAdie, global head of credit research at BNP Paribas in London, believes there are signs that an orderly exit will ultimately be possible.

“The BoE has been selling some corporate bonds out of its portfolio at a handsome profit, the same with the Fed on some of its MBS. I would be fairly certain that they will slowly liquidate securities as and when they deem fit, and it will in no way destabilise markets but will instead be a chance to improve the central banks’ balance sheets,” he says.

Not yet deep enough

Even assuming an eventual exit, this still leaves the profound question about how to prevent moral hazard in the financial system. If central banks are willing to innovate to combat liquidity squeezes, this could encourage excessive risk-taking in commercial bank funding strategies. That could in turn undermine the transmission mechanisms for monetary policy in good times.

The liquidity requirements in the proposed Basel III international bank regulations are one way to push banks to improve their own liquidity risk management. But Mr Kroszner believes a 'laser focus' on the management of maturity mismatch will be needed to avoid central banks falling back on extraordinary interventions too frequently.

“Markets are already much more focused on the questions of funding stability than they seemed to be before the crisis, when they did not penalise financial institutions that had risky funding structures. But we also need a supervisory approach that focuses on scenario analysis, looking at unlikely circumstances but ones that can obviously happen, and thinking about how banks and other financial institutions can be protected against disruptions in their markets,” he says.

We also need a supervisory approach that focuses on scenario analysis, looking at unlikely circumstances but ones that can obviously happen, and thinking about how banks and other financial institutions can be protected against disruptions in their markets

Randall Kroszner

The European approach appears to favour intervention more than market discipline. Mr Nauschnigg at the Austrian National Bank believes a broader role for the ECB is permanent and inevitable. The European Systemic Risk Board launched in January 2011 to partner the ECB can provide an early-warning mechanism, but he has also advocated tougher macroprudential tools such as a stabilisation tax that kicks in if credit growth is too high in a particular eurozone market.

“There are those who still believe in the theory of efficient markets, but for me one of the lessons of the crisis is that we should be prepared to intervene if markets malfunction, as we have done with the SMP,” says Mr Nauschnigg.

Sailing somewhere between the US and eurozone, Mr Fisher says that while the BoE will look for ways to tighten conditions if it sees bubbles forming, it is not possible to prevent bubbles altogether. The UK is launching a consultation process on macroprudential regulation from September 2011, with a view to passing legislation by 2013.

“The way the consultation is worded is to make the system more resilient to the cycle, so when the bubble bursts, the system does not fall over. Maybe we can help dampen the cycle as well, but the safer you make the system, the more people think they can take risks. The better you make the roads and the brakes on cars, the faster people drive,” he says.

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