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5 Central bank impotence and market
liquidity By Henry C K Liu
asset depreciation or disinflation
or deflation which can only be cured by currency
devaluation which translates into inflation. Some
economists, including Bernanke, the new Fed
chairman, support inflation targeting as a viable
monetary policy option.
Fixing the
market liquidity drought The cut of the
discount rate is designed to tackle the liquidity
drought in the banking system and to keep banks
liquid to prevent
financial markets from
seizure. The new policy statement signals that the
Fed stands ready to cut interest rates if
necessary to deal with the contagion effects of
the subprime mortgage-generated liquidity crisis
on the real economy.
The objective is to
restore the flow of funds through the banks into
the financial system to limit the damage to the
real economy. Whether intended or not, the Fed's
new policy stance sparked speculation that the
European Central Bank, which injected over 150
million euros (US$203 million)into its banking
system in previous days, might be forced to back
off raising euro interest rates in September to
prevent the euro from rising further. Up to the
time of the discount rate cut on August 18, the
Fed had to repeatedly pumped liquidity ($52
billion) into the financial system through the
repo market to keep the overnight Fed Funds rate
from rising above its target of 5.25%. This Fed
monetary market tactic has been described by
market participants as the Fed practicing "stealth
easing" or "synthetic easing"; that is, to inject
funds without lowering the Fed Funds rate. But
while the Fed hoped to restore liquidity to
financial system with an injection of some $52
billion to the overnight money market, this
injection failed to impress the market.
Three-month lending rates remained high and the
asset-backed commercial paper and jumbo mortgage
market remained dysfunctional. The stock market
continues to fall after a brief reprieve.
Ready investors for debt instruments of
all sorts have become endangered species in this
market seizure. The Fed is determined to restore
liquidity in these seized markets to fulfill its
mission of keeping markets functioning. It also
believes that the longer credit markets stay
seized, the bigger the risk of disrupting the flow
of credit to households and businesses in the
economy to induce a recession or worse. Yet moving
aggressively on the discount window front will
ensure availability of funds to the banking system
to keep banks solvent but it may not help to get
markets working unless the Fed is prepared to drop
massive amounts of dollars from helicopters on
main street, as Bernanke once quipped before
becoming chairman.
The Fed has not changed
the nominal rating level of securities eligible
for these operations even though the ratings have
been decoupled from the real market price of the
securities. By reducing the penalty rate on
discount window lending from 100 basis points over
the federal funds rate to 50 basis points, and
allowing banks to obtain 30-day loans rather than
overnight money, the Fed ensures that banks
encountering difficulties securing finance against
mortgage-backed and other collateral have assured
access to liquidity at reasonable rates. And many
banks are encountering such difficulties as they
fail to find buyers in the debt market for the
asset-backed securities they hold as collateral
for bank loans made to hedge funds and private
equity groups.
Central bank
impotence But the time has long passed
when central banks adding liquidity to the
financial system could help a liquidity crisis in
the market. When the Fed injects funds directly
into the money market through the repo window,
banks and thrifts and other non-bank financial
institutions that need funds can participate. With
the daily volume of transactions in the hundreds
of trillions of dollars in notional value of
over-the-counter derivatives, the Fed would have
to inject funds at a much more massive scale to
affect the market. Such massive injection would
mean immediate and sharp inflation. Worse yet, it
would cause a collapse of the dollar.
When
the Fed adds liquidity directly into the banking
system through the discount window, it injects
high-power money into banks by making interest
rates for overnight interbank banks loans within
its set target. The theory is that banks will in
turn be able to make loans at interest rates
deemed appropriate by the Fed, thus relaying the
added liquidity to the market in multiple amounts
because of the mathematics of partial reserve.
But just because banks are able to make
loans at low interest rates does not mean banks
can find borrowers with credit ratings to justify
the low rates. John Maynard Keynes' concept of a
liquidity trap is that market preference for cash
positions can outweigh interest rate
considerations. In a financial crisis, there may
simple not be enough credit-worthy borrowers at
any interest rate level and the number of sellers
stays stubbornly larger than the number of buyers
because sellers need to sell precisely because
they do not have credit worthiness to borrow, even
at low interest rates, and buyers stay on the
sideline waiting for even lower prices.
Even when the Fed lowers the discount
rate, banks will only see their threat of
insolvency reduced. Banks will still be sitting on
piles of idle cash that they cannot lend. This is
known as banks pushing on a credit string. Keynes
insightfully observed that the market can stay
irrational longer than most participants can stay
liquid. Since central banks are now mere market
participants because of the enormous size of the
debt market due to the widespread use of
structured finance with derivatives whose notional
value adds up to hundreds of trillions of dollars,
the market can stay irrational longer than even
central banks can stay liquid, if central banks do
not want to drive their currencies to the ground.
With deregulated global financial markets,
central-bank capacity for adding liquidity to the
banking system is constrained by its need to
protect the exchange value of its currency. For
the US, which depends on foreign central banks to
fund its twin deficits, any drastic fall of the
dollar will itself create a liquidity crisis from
foreign central banks shifting out of dollars in
their foreign exchange reserves.
Federal
Reserve flow of funds data show outstanding home
mortgages in the first quarter of 2007 to be at
$10.4 trillion. About $1 trillion in mortgages is
due for reset by the end of 2007 alone. A 4% reset
of interest rates on $1 trillion of mortgages
would require addition payments of $40 billion.
Agency and GSE-backed mortgage asset amount to
$3.9 trillion. Issuers of asset-backed securities
home mortgages' assets amount to $1.9 trillion.
The numbers are further magnified hundredfold by
structured finance with high leverage which
magnifies the cash flow caused by even the
slightest interest rate volatility.
Liquidity problems associated with
counterparty default could quickly run up to
trillions of dollars. What does the Fed hope to
accomplish with injecting a mere $50 billion or
$100 billion into the banking system, except to
show its impotence? The Fed can keep the banks
from failing, but it cannot prevent the harsh
reckoning of a debt-bubble economy.
What is market liquidity? After
all, what is market liquidity? Economists refer
frequently to liquidity in the abstract, yet in
reality, liquidity is difficult to define and even
more difficult to measure and almost impossible to
restore because it is hard to know where the weak
links are.
On Wall Street, liquidity
refers to the ability to buy or sell an asset
quickly and in large volume without substantially
affecting the asset's price. Shares in large
blue-chip stocks like General Electric used to be
considered liquid, a description long since
rendered invalid because of market volatility.
Of the several dimensions of market
liquidity, two of the most important are tightness
and depth. Tightness is a market's ability to
match supply and demand at low cost (measured by
bid-ask spreads) quickly, while market depth
relates to the ability of a market to absorb large
trade flows without a significant impact on prices
(approximated by volumes, quote sizes,
on-the-run/off-the-run spreads and volatilities).
When market participants raise concerns about the
decline in market liquidity, they typically refer
to a reduced ability to deal without having prices
move against them, that is, about reduced market
depth.
Cycles of liquidity crises have
been a recurring feature of financial markets.
Commonly used indicators of market liquidity are
notoriously imperfect as reliable measures of
liquidity conditions. While conditions in the
autumn of 1998 were indeed identified as
reflecting the adverse shock of the 1997 Asian
financial crisis to liquidity in financial
markets, liquidity indicators seemed to suggest
that, with the notable exception of the US
government bond market, liquidity conditions were
broadly restored to pre-crisis levels within a
short period in the US.
However, the usual
indicators typically capture only a single
dimension of market liquidity and none of them
were forward-looking in nature, making it
difficult to draw any conclusions as to how
long-term future liquidity conditions were being
shaped by responses to current liquidity stress.
Bubbles are the bastard children of liquidity
overshoots.
While idiosyncratic factors
might be cited as being responsible for the
perception of low liquidity in specific markets,
reduced market liquidity is unlikely to be a
purely conjuncture phenomenon. From a financial
stability perspective, some of the structural
factors at work can be highlighted, focusing on
developments bearing on liquidity conditions in
the integrated global financial system at three
different levels, namely: 1.
Firms: developments at the level of
major financial firms participating in the core
financial markets. 2. Markets:
developments in the structure and functioning of
markets themselves. 3. System:
developments across the global financial system as
a whole, such as the systemic effects of credit
derivatives.
Liquidity and credit
risks Such structural developments may have
served to reinforce the links between liquidity
and credit risks, but also the distinction between
normal conditions and abnormal conditions and
between normal times and times of stress when
confidence declines. The current challenge is one
of returning an abnormal economy of excess
liquidity to an economy of normal liquidity
without extinguishing the flame of liquidity
entirely.
The period of stress will be the
time it will take to work off the excess
liquidity, to turn the liquidity boom back to a
fundamental
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