Central Banks as Market Makers of Last Resort 5; A Restatement

Joint post by Willem H. Buiter and Anne C. Sibert. Virtually the same post appeared in Martin Wolf's Economists' Forum , on Sunday 2 September 2007.

Martin Wolf, Chief economics commentator of the Financial Times, in his column, 'Central banks should not rescue fools', criticises our Market Maker of Last Resort (MMLR) proposal (see (1) , (2) , (3) and (4)). Not surprisingly, we disagree with his comments and we respond and clarify.

Central banks should support key financial institutions with strong public goods features. These institutions include important financial markets and mechanisms that support these markets, such as the payments system and clearing and settlement systems. Central banks should not support or bail out financial businesses or households unless this is necessary to support key economic institutions (it is not helpful that financial businesses are sometimes referred to as financial institutions).

In Bagehot's days, commercial banks accounted for the lion’s share of financial intermediation. They were the credit system and played a key role in the payments system. Support of the credit markets and the maintenance of a functioning payments system therefore required the support of commercial banks in a financial crisis. Thus, Bagehot advised that in times of crisis the central bank should lend (to commercial banks) freely, at a penalty rate and against good collateral (that is, collateral that would be good in normal times but has become impaired temporarily because of the crisis). A penalty lending rate and the collateral requirement serve to minimise moral hazard.

Today, a growing share of financial intermediation bypasses commercial banks completely, going through financial markets in which commercial banks are just one of many types of participants. It now becomes possible to support the credit system and key financial markets without supporting individual, or even particular types of financial businesses.

We propose that liquidity problems can be addressed by the central bank making a market for assets which would be liquid in normal times but are illiquid because of the crisis. The central bank can do this either by buying the asset outright or by accepting it as collateral against loans at the central bank’s discount window or in repurchase operations in the money markets.

Our proposal expands the set of what is generally considered “good” collateral for Bagehot’s Lender of Last Resort. We suggest that central banks accept a much wider range of assets as collateral than is currently the case. Specifically, they should accept securities that are below investment grade (‘junk’), and accept securities backed by impaired assets such as impaired subprime mortgages. The ECB’s self-imposed rules of practice prohibit accepting as collateral, either in repos or at its discount window, anything rated less than A-. The Fed is permitted to accept anything as collateral at its discount window, but has done little to enlarge its menu of eligible collateral.

We maintain Bagehot’s requirement that lending be at a penalty rate. Central banks should only offer to buy an illiquid asset at a punitive price, that is, at a price representing a severe ‘haircut’ or discount relative to what its fair or fundamental price would be with orderly markets. This could be implemented as follows. First, the monetary authority should clarify what kinds of assets it is in principle willing to purchase.

Martin objects that the central bank would have to end up dealing in and setting prices for complex structured instruments that it knows little or nothing about. Clearly, there would have to be a ‘positive list’, updated regularly, of securities eligible for discounting. Only systemically important instruments would have to be considered, not every over-the-counter concoction some quant has dreamt up. Then, the central bank would have to be active, even during normal times, albeit on a small scale, in the market for each of the eligible instruments. That way the central bank staff will acquire a familiarity with the instruments that will be helpful during disorderly market conditions. What we are recommending for this wide range of eligible instruments is what central banks routinely do in the foreign exchange markets, even when the exchange rate policy is a free float. The central bank would have to recruit staff with new skills, or retrain existing staff, to do this affectively.

The central bank should only deal with and lend to “eligible” counterparties. Eligible counterparties are all those who abide by a prudential regulatory/supervisory regime approved by the central bank. Financial businesses that do not abide by these regulatory and supervisory constraints cannot come to the discount window and will have to try their luck obtaining liquidity from those that do meet the prudential norms.

How can the central bank set a price in a market that has ceased to function? There are many ways of structuring markets or auctions in such a way that they become price or value discovery mechanisms. An example of such a mechanism - one which discovers the reservation prices of all potential sellers without the central bank having to have any superior knowledge of the fundamental determinants of the value of the illiquid security - is the Dutch auction.

For a given eligible instrument and a give set of eligible counterparties, the central bank would announce that it is willing to buy up to, say, $10bn (at face value) of an impaired asset. It would start the auction by offering to the asset at, say, one cent for each dollar of face value. All sales at that price would be accepted, up to the $10bn face value limit. If the total amount offered at one cent on the dollar were to exceed $10bn face value, there would be pro-rata sharing among those who made offers to sell. If less than $10bn face value is offered at one cent on the dollar, the central bank would increase its bid. Thus if, say, $2bn were offered, the central bank would allocate the $2bn to the sellers who accepted one cent on the dollar and then would offer to buy up to $8bn at, say, 2 cents on the dollar. The central bank would then continue this process, offering increasingly higher prices, until it had purchased the entire $10bn.

The central bank as Market Maker of Last Resort effectively performs the role of a publicly owned 'vulture fund', buying up distressed, illiquid assets from sellers desperate to realise some value somewhere. Martin argues that this job should be left to regular private vulture funds. We agree that if private vulture funds can do this in a timely matter, so much the better. There are times, however, when waiting for private vulture funds to step forward risks an avalanche of illiquidity that creates unnecessary and socially costly defaults and bankruptcies. In such circumstances, only the central bank has the deep pockets to make a market in an expeditious fashion.

© Willem H. Buiter and Anne C. Sibert 2007