Thursday, August 23, 2007

Central banks as market makers of last resort 4; liquidity, markets and mechanisms


Liquidity, the ability to sell an asset for cash at short notice, at a price close to its fair or fundamental value and with low transaction costs, is a property of assets that some assets never possess, others (almost) always, and yet others intermittently and/or to varying degrees. The reasons for illiquidity can be divided into three categories: (1) legal restrictions on the ability to sell; (2) technical, physical or informational obstacles resulting in the absence of organised markets and permitting only infrequent and often unpredictable opportunities to sell; (3) Knightian uncertainty, fear and panic resulting in disorderly conditions in normally well-functioning markets; at best, prices significantly below fair or fundamental value can be realised; at worst, there is the effective temporary closure of normally well-functioning markets. For this third category, the maxim holds that, as regards private securities and in the absence of state intervention of the lender or last resort or market maker of last resort variety, liquidity is everywhere when you don’t need it, but is nowhere to be found when you need it.

As regards the legal restraint reasons for illiquidity, legal restrictions account for the illiquidity of the most important form of wealth, human capital, the present discounted value of current and future labour earnings. With both slavery and indentured labour illegal (for excellent reasons not captured by conventional economic analysis), it is not possible to sell your own human capital, or that of others, or to buy the human capital of others. While you could, I suppose, sign a contract promising to make future payments that matched your own labour income, this would be a highly imperfect substitute for the ability to sell you own labour services for two reasons. The first are asymmetric information (the other party to the contract and third parties may not be able to verify your labour income, which could be private information) and moral hazard (having sold the contract, you would have an incentive to work less hard); the more important one is that your own labour income could not serve as collateral for the payments on the contract you just signed; ‘free labour’ means no court would enforce a contract that had your own future labour income as collateral.

As regards ‘technological (including informational) reasons for illiquidity, assets whose payoffs are contingent on events whose occurrence is private information are unlikely to be tradable and liquid. This may be one reason why loan contracts agreed between a commercial bank and a borrower tended to be illiquid. Banks issued loans to borrowers and kept them on their books until the loan matured. The information required to verify the reasons given by the borrower for non-performance was available, at best, to the bank’s loan officer, who might be familiar with the circumstances and characteristics of the borrower because of a long-standing relationship.

The securitisation of previously illiquid bank loans ‘solved’ the illiquidity problem of bank loans only at the cost of destroying valuable information about the borrower. The argument that this destruction of information would not happen because the originator of the loan (the commercial bank through the efforts of its loan officers) would, because of reputational considerations, spend the same amount of resources and effort selecting, supervising and monitoring the ultimate borrower, even after the loans had been sold off to some special purpose vehicle created by (and generally owned by) the bank, is unconvincing. The loan officer worked directly for the principal in the traditional illiquid bank loan scenario. When the loans have been securitised, the banks loan officer is one agency relationship further removed from the principal, and should be expected to shirk more. This point that, by adding more tiers, layers or agents into the principal-agent relationship, incentives and effort get eroded is a simple one, but has not been emphasized enough in the discussion of the effects of securitisation of bank lending (or of credit card receivables, or of mortgages) on the incentives faced by the agent in charge of selecting, supervising and monitoring the ultimate borrower. We are paying the price for this in the US markets for securities backed by mortgage receivables and in the UK in the market for securities backed by credit card receivables.

As regards uncertainty, fear and panics as reasons for illiquidity, the developments of these past few months have brought home two truths. First, many assets secured against traditionally illiquid receivables (mortgages for instance) were never very liquid to begin with. Where are the organised exchanges on which CDOs secured against subprime mortgages or high-risk credit card receivables were widely traded? Most of these assets were bought from SPVs (often created by the banks who previously held these receivables as illiquid investments) by hedge funds and other more jazzy financial institutions, who expected to hold them to maturity. These hedgefunds and similar highly leveraged private financial enterprises may, however, have believed that their investments were liquid, i.e. that they could be disposed of at short notice and with low transaction costs at a price close to their fundamental value. This may have been true when optimism, euphoria and greed ruled the roost in financial markets. It definitely was not true when uncertainty, fear and panic took over as the driving mood among the herd of financial market players.

The financial chaos of the past few weeks has made it clear that, unless the fundamental value of a security can be verified objectively and at little cost by both parties to a contract and by third parties, no security can be confidently expected to remain liquid when uncertainty, fear and panic strike. This means that no private security whose valuation requires an assessment of the default risk of the issuer (and of the payments receivable conditional on default occurring) can be expected to remain liquid when uncertainty, fear and panic strike. Only one class of securities is unaffected by this. These are securities issued by solvent central governments and denominated in the national currency. This is because default is not an issue there. The power to tax and the power to declare (some of) its liabilities to be legal tender are unique to the state, which has the monopoly of the legitimate use of force and coercion. Until private entities emulate that state as regards the use of force and coercion, the private sector will be unable to create liquidity in a credit and liquidity crunch. One could make the argument that there is a second class of securities whose liquidity is unlikely to be dramatically affected by the emergence of default risk. That would be equity. This is because equity always lives in the shadow of default, since when default occurs, equity is (supposed to have been) wiped out.

Support/bail out markets and mechanisms, not financial businesses

Central banks in times of crisis should aim to support/bail out markets and other valuable social mechanisms; they should not support or bail out companies, partnerships or individuals, unless this is an unavoidable feature of supporting markets and mechanisms. Specifically, they should not support (again subject to the same caveat) financial institutions, which are of course not institutions at all, but only misnamed financial businesses.

The mechanisms that warrant central bank support and bail outs are the payments, settlement and clearing mechanisms for goods, services and securities. The financial markets that warrant supporting are those that are, directly or indirectly, of material importance in (1) the intermediation of the flow of saving from economic agents with financial surpluses (mainly households) economic agents with financial deficits (mainly non-financial enterprises and governments), and (2) the management of the financial wealth of the ultimate wealth-owning entities in the economy, households and the state.

So the households that overextended themselves with mortgages that turned out to be too large or otherwise inappropriate should not be bailed out, either by the Fed through lower interest rates or, ex-post, by the mortgage industry regulator leaning on the lenders to delay/forestall foreclosures. If hardship and poverty result from this, the appropriate existing government programmes for dealing with hardship and poverty should be used to address these problems. It is hard to believe that hardship and poverty resulting from foreclosures is a greater social problem than hardship and poverty resulting from other causes (ill-health, for instance).

The mortgage lending institutions will take a hit if the value of their collateral (the homes against which the mortgages were secured) is less than the value of the outstanding obligations at the time of foreclosure. Its equity owners and its creditors, (including its depositors, to the extent they are not covered by deposit insurance) may lose some of all of their investments. That is as it should be, and does not call for government or central bank intervention.

If inappropriate lending practices were pursued by the mortgage lenders or if inappropriate products were offered to borrowers, the first party to be held to account, after the lending institutions themselves, are the regulators and supervisors. This may help prevent or mitigate the next crisis, but will do nothing to mitigate the current one.

The German banks that invested equity in or lent money to funds and other special purpose vehicles which decided that financial instruments backed by US subprime mortgages were a good bet should be allowed to go under, if their equity is wiped out by the subprime debacle. Many of these banks are Landesbanken (perhaps they would prefer to be Landesbänke) whose future without government guarantees in a competitive Europe-wide or even global banking market is doubtful at best. Others, like IKB, have a wholly state-owned bank as its major shareholder. If this financial crisis speeds up their exit from the market, it will be a boost to the efficiency of the European credit and capital markets.

What to do if a business is the market or the mechanism

I believe that the view developed by Anne Sibert and myself in central banks as the market maker of last resort (MMLR) (see e.g. Willem H. Buiter and Anne C. Sibert “The Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort"; Willem H. Buiter “Central banks as market makers of last resort, again”; Willem H. Buiter and Anne C. Sibert “A missed opportunity for the Fed”), is quite consistent with, and indeed encompasses, Walter Bagehot's view of the central bank as the lender of last resort (LOLR). When Bagehot wrote, commercial banks (with sight deposits withdrawable on demand and subject so a sequential service (first-come, first-serve) constraint and illiquid business loans as assets, were the market for credit. Intermediation from saving households to investing non-financial enterprises went through the banks. So to save intermediation from ultimate savers to ultimate investors, and to save the market (a goal we agree with because the credit market is a public good ‘on steroids’ because it is subject to network externalities) the central bank had, in times of financial turmoil and panic, to save the banks. It therefore had to lend freely., To minimise moral hazard, it had to lend at a penalty rate and against collateral that would be good in normal times, with orderly markets, but could have become bad in abnormal times, with disorderly markets.

With the financial developments since Bagehot, and especially those since the 1960s, the commercial banks have become much less important in the intermediation process between households, non-financial enterprises and governments. Other financial businesses (a better name than the excessively venerable epithet ‘financial institutions’) such as investment banks, pension funds, insurance companies and highly leveraged financial businesses such as hedge funds and private equity funds, have taken away much of their business. All these players (including households, commercial banks and non-financial businesses, are now less prone to be involved in long-term relationships with each other, and are now more likely to interact through the financial markets. Of course, repeated interaction through the issuance and purchase of the securities in the financial market may establish connections that share some, but not all, of the features of the traditional long-term relationship between commercial banks as their customers on both sides of the balance sheet.

A few of these financial businesses still play a unique role in some of the key financial markets or mechanisms because of institutional inertia. Central banks tend to restrict access to the discount windows to a highly restricted set of counterparties, mainly commercial banks. It seems obvious that this legacy of history no longer makes any sense and is an obstacle to the efficient management of financial crises by the central bank. Any counterparty (individual, partnership or company) that holds the kinds of securities accepted by the central bank at its discount window should be able to access the discount window, provided the counterparty is willing to accept the appropriate prudential regulatory and supervisory restrictions on its behaviour. It is the duty of the central bank to work out what the appropriate prudential regimes for this heterogeneous collection of potential counterparties are.

In its regular liquidity-providing repo operations, I can see no reason for the eligible counterparties of the central bank to be restricted to any party that meets the central bank’s criteria for creditworthiness and is able to offer collateral that meets the central bank’s collateral eligibility requirements.

I also believe that the eligibility requirements for collateral should, at least in times of crisis, be relaxed to include non-investment grade securities and securities with much longer terms remaining to maturity than has been the case thus far. Of course, for the central bank to act sensibly in the markets for non-investment grade securities (whether through outright purchases or by accepting them as collateral in repos or discount window operations) during times of crisis, it has to be present in these markets all the time, regularly buying and selling small amounts of securities, to familiarise itself to the fullest extent possible with these markets.

Payment, clearing and settlement mechanisms

The payment, clearing and settlement mechanisms for goods and services and for securities provide a public good. This means that its provision by unregulated competitive markets will be at best inefficient and at worst disastrous.

State provision is also likely to be inefficient, basically because, as a near-universal empirical generalisation, the state is inefficient at just about any productive activity it attempts to manage and run. The ECB currently manages Target1/2 (basically the large-scale interbank payments in the Eurozone). I have no metric against which to evaluate the efficiency of their performance of this function. Nevertheless, I believe that, regardless of the efficiency of the ECB in managing and running Target1, that responsibility should be taken away from it. The reason is that the ECB is ‘too independent’ to be entrusted with any task/function other than the one for which this extraordinary degree of independence may make sense (monetary policy). The institution looking after the plumbing and wiring of the payments, settlement and clearing system should be an institution whose managers and board can be fired for incompetence, and whose mandate can be changed without a process that requires the unanimous approval of 27 EU members. The same argument applies to Target2-Securities, the clearing and settlement system for securities that the ECB proposes to own, manage and run. Even if there is a case for a public sector agency to run the securities clearing and settlement systems, it should, for substantive accountability reasons, not be the ECB (see my inaugural lecture at the LSE for details).

Private (for profit) provision under strict regulation (and possibly with the support of some state funding) is therefore the obvious arrangement. The alternative is to restrict entry into the payments, settlement and clearing system to not-for profit private ventures (a revival of mutuals perhaps?).

The payment, settlement and clearing systems in the EU and elsewhere should be taken away from private profit-oriented financial businesses for which these tasks are but a small fraction of their total portfolio of activities. The reason is that the performance of these essential but, from the point of view of the total resources involved, minor tasks of providing payment, settlement and clearing systems, allows the private businesses offering these systems and services to extract massive rents from the state and from their customers, benefiting the entirety of their business activities and not only the units devoted to providing payment, clearing and settlement services. This is most patently the case during financial crises, when the only way to safeguard the payment system often appears to be to safeguard the commercial banks that currently provide many of these payment services. The interest rate cuts sought by the commercial bank lobbyists (and by all those who stand to benefit from enhanced access to cheaper finance) are an extraordinarily inefficient way of safeguarding the payment system. Interests rate cuts aimed at supporting the payment system end up supporting those whose recklessness led them into excessively leveraged speculative activities.

The intermingling, in private profit-oriented businesses, of the provision of public goods or services with regular profit-seeking activities, represents an extremely unhealthy state of affairs. The public provision of private goods is a well-documented disaster. The private provision of a public good without effective regulation (especially when provision is by a complex private businesses for which the public good is but one concern among many), can be a disaster of comparable magnitude.

© Willem H. Buiter 2007

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