THE LENDER OF LAST RESORT
AND LIQUIDITY PROVISION –
HOW MUCH OF A DEPARTURE IS
THE SUBPRIME CRISIS?
E Philip Davis
Brunel University and NIESR
London
philip.davis@brunel.ac.uk
groups.yahoo.com/group/financial_stability
Introduction
• We first consider importance of liquidity risk in crises
and traditional policy response of the Lender of Last
Resort (LOLR), based on current attitudes and beliefs
• Then we assess how the sub-prime crisis has changed
the situation, viewed against this benchmark:
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New forms of liquidity risk
New responses of LOLR
New challenges for LOLR
Coping with the (more) systemic crisis since September
2009
Nature of LOLR and liquidity risk
• Traditional nature of LOLR is set out based on current
understanding and beliefs and not what Bagehot wrote
• Vulnerability of banks to funding liquidity risk,
inadequately offset by banks own liquidity policies
• Hence LOLR - discretionary provision of liquidity to offset
an adverse shock that creates an abnormal increase in
demand for liquidity - prevent illiquidity leading to
insolvency and contagious runs - lend freely and
temporarily at a penalty rate against good collateral
• In modern system can be direct lending or open market
operations, also off balance sheet guarantees. Are only
OMO needed? (Goodfriend/King vs Goodhart)
• Any direct lending against collateral and to banks only
(systemic importance and market discipline)
Costs of LOLR
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Possibility of supporting insolvent
Lesser incentive to hold liquidity
Increased moral hazard in lending
Increased scope for forbearance if offered to insolvent
Too big to fail
Conflict with other policies
Minimising costs of LOLR
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Supporting only systemic institutions
All alternative sources of funds exhausted
High quality collateral and penalty rate
Seeking private sector solution
Ensure adequate information
Avoiding monetary and fiscal conflicts
Ambiguity and secrecy – also avoids stigma
Spell out ex ante conditions?
Domestic currency only?
LOLR in systemic crises
• Narrative based on experience is recent crises (e.g. Asian
crisis of 1997)
• In panic, flight to quality and widespread contagion,
reassure public by visibility
• Uniform support even to insolvent and non systemic
(Ministry of Finance backing)
• Relax collateral requirements and penalty rates
• Part of wider crisis management, including macro policy
easing, blanket deposit insurance guarantee and
government recapitalisation
• Very high costs to LOLR and government
The sub-prime crisis and liquidity
• Overall understanding requires to supplement bank
funding risk with market liquidity risk, and bank policies
of mark to market and balance sheet management
• The non systemic period (August 2007-August 2008)
– Realisation of risks of sub-prime plus uncertainty about
valuation of ABS…
– …led to ABS sales, leading to market liquidity failure, with
price falls due to liquidity risk and lower risk appetite, not just
credit risk, Markets for securitisation closed generally
– Aggravated by margin requirements and credit limits on
arbitrageurs, and restriction on risk appetite of market makers
– Rush to sell worsened by mark to market’s impact on capital of
institutions and solvency – contrast to banking crises of past
with book values
– Contagion spread via market collapse of ABCP financing
conduits and SIVs
– And via traders attempts to hedge, meet margin calls and
realise gains in more liquid markets – cross market
contagion
• Market liquidity’s impact on funding risk
– Effect on interbank via inability of banks to securitise,
backup calls from conduits and SIVs, and suspicion of
other banks’ solvency due to price of ABS
– Hence hoarding of liquidity, and wide spreads in interbank
market, also quantity rationing of funds, especially at
longer maturities
– Collapse of Northern Rock due heavy dependence on
wholesale funds, and later of Bear Stearns
– Close relation of funding risk to market liquidity risk
revealed overall
• The Systemic period (September 2008-)
– Failure of Lehmans leading to complete drying-up
of wholesale markets, including commercial paper
– Problems for money market funds breaking the
dollar – also mutual funds and hedge funds
– Massive redemptions leading to sales in illiquid
markets
– Flight to quality in government bonds
– Bank failures and government recapitalisations
– Crisis spreading to real economy – risk of adverse
feedback loop (Bernanke)
Relevant liquidity risk paradigms
• Some standard elements
– Asset price fall leading to liquidity shock
– Deterioration of loan quality
– Fire sales and runs
• Market liquidity risk and liquidity insurance
(Davis, Bernardo and Welch)
– Reconsider Diamond-Dybvig for markets
– Rationality of selling if fear liquidity will collapse
– Externalities similar to bank failures – fire sales,
funding problems, contagion to other markets, as
with ABS, ABCP, interbank
– Role of market makers in uncertainty or asymmetric
information – uncertainty regarding ABS valuation
and on counterparties
– Dynamics relating to dealers’ capital
– Becomes impossible to sell assets, e.g. primary
securitisation markets
• Contagion via market price changes in context of
mark to market (Adrian and Shin)
– Financial institutions’ active balance sheet
management, positive relation of leverage and balance
sheet size
– Desired expansion in upturn, boosting liquidity
– Shock to prices led to desired contraction, but stopped
by obligations (e.g. backup lines) – so cut back on
discretionary lending - interbank
• Interbank funding liquidity (Freixas et al)
– Imperfect information or market tension can lead
to shortages of funds even for solvent banks
– “Bank runs” in market occur as banks hoard
liquidity
• Amplifying mechanisms of liquidity shocks
(Brunnermeier)
– Borrowers balance sheet effects – loss spiral and
margin spiral
– Lending channel effect – hoarding liquidity
– Runs on institutions and markets
– Network effects – Goldman Sachs and Bear
Stearns
LOLR and the sub-prime crisis –
non systemic period
• Needed to evolve to cope with new conditions
- compared in this section with traditional
views
• Re: nature of LOLR
– Open market operations more than direct lending expansion to longer maturities
– Protracted crisis – fear NCBs lacked instruments?
– Investment banks covered – Bear Stearns and
liquidity facilities – reflect central role in financial
system but not regulated by Fed
– Related innovation use of SPV in LOLR
• Re: costs of LOLR
– Ambiguity of lending to reliquify markets – impact
on solvency of institutions
– Conflicts with other policies, need to maintain
monetary stance and difficulty of interpreting
stance given LIBOR spread
– How much moral hazard generated by “new”
LOLR?
• Re: minimising costs of LOLR
– Reduction in collateral standards…
– …even ABS, reliquified by non market means –
market maker of last resort – or even first
– Inversion of traditional NCB role, adverse
selection and moral hazard
– Private sector solutions sought but not found for Northern Rock,
only with guarantee for Bear Stearns – wide scale of problem
and uncertainty on valuation
– Adequate information for LOLR, not the case for Bank of
England in Northern Rock case
– Loss of reputation to banks receiving LOLR notably Northern
Rock – decision to be overt in lending and leakage of
information – need for new facilities instead of discount window
– Conflict with a partial deposit insurance scheme in the UK –
reason for rescue?
– Domestic LOLR insufficient – cross currency swap arrangement.
Need for cooperation and risk of “gaming”. Fortunate no cross
border failure?
– Challenge for exit strategies to prevent moral hazard to reactivate
markets
LOLR and the sub-prime crisis –
systemic period
• Response of fiscal authorities to crisis,
complementing LOLR
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Recapitalisation
Overriding of merger policy
Extension of deposit insurance
Purchase of illiquid or impaired assets
US guarantee of money market funds
• LOLR activity
– Growth in central bank balance sheets, partly due to lesser
penalty rates/narrower “corridors”
– Mainly developing from earlier innovations
• Types of collateral
• Expansion of cross border activity, e.g. US bilateral swaps
• Some innovations – UK standing facilities
• LOLR changes mainly in US
– Providing funds direct to borrowers and investors in
markets rather than via intermediaries, acting as “market
maker of last resort” or even “investor of last resort”, via
SPVs, generally “breathe life into impaired markets”
– Market support for commercial paper, MBS…
– Purchasing GSE obligations
– Further support for money funds
– Institution support for Citicorp, AIG….
– Would Lehmans have been rescued had the law been
changed earlier?
• On balance, classic response to systemic crisis except
for US further extension of LOLR role
Conclusion
• Liquidity risks endemic to banking, first response is
bank liquidity policy, but also LOLR
• LOLR doctrine is to avoid unnecessary systemic
failures, safeguard NCB balance sheets and minimise
moral hazard
• Sub prime showed that liquidity risk assessment
needs rethinking to allow for interaction of market
liquidity risk and funding risk
• LOLR challenges include:
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longer term provision
variety of lower quality collateral
including investment banks in the safety net
confidentiality of bank support
interaction with deposit insurance
• Has the net effect of these changes been to
increase moral hazard?
• Innovation mainly in non systemic period
• Issue of exit strategies, not least given size of
central bank balance sheets
• And need for reform of liquidity regulation –
FSA model?