E Philip Davis Brunel University and NIESR London philip.davis@brunel.ac.uk

1. 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

2. 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: • New forms of liquidity risk • New responses of LOLR • New challenges for LOLR • Coping with the (more) systemic crisis since September 2009

3. 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)

4. Costs of LOLR • 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

5. Minimising costs of LOLR • 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?

6. 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

7. 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

8. 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

9. 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)

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. LOLR and the sub-prime crisis – systemic period • Response of fiscal authorities to crisis, complementing LOLR • 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

17. 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

18. 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

19. LOLR challenges include: • 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?