Mon May 9th, 2011 at 03:54:21 PM EST
Last week, the think-tank Bruegel published an article entitled ESRB should act on sovereign risk containing an extremely important idea:
The ESRB is the institution uniquely placed to make such an assessment [of the systemic implications of a Greek debt restructuring]. First, it has probably the best access to the kind of data needed to make such an assessment. The ECB - providing a large part of the infrastructure of the ESRB - knows which banks use Greek bonds as collateral for the open market operations and should therefore have a good picture of exposure to Greek bonds. The ECB should also have fairly detailed information on the interbank market, from which contagion across banks can be assessed. Last but not least, the ESRB has the legal authority to request data from the national and European supervisors needed for such an assessment. The assessment would obviously have to take into account the possible contagion effects.
Leaving aside the perhaps understandable (given the state of economic conventional wisdom) but still inexcusable (especially in an economist) confusion between open market operations
(what the article says) and main refinancing operations
(what the article should
say, as open market operations are both anonymous and uncollaterallised), here we have a restatement of a truth which is central to Hyman Minsky's book Stabilizing and Unstable Economy
. Namely, that the Central Bank should emphasize refinancing operations (i.e., collateralised lending) through the discount window
(a term more familiar to the general public than main refinancing operations
) over open market operations
as a way to foster greater financial stability. I'll explain in detail why this is so after the fold, with quotes from Minsky. In any case, it's a good thing that, 25 years after Minsky wrote his book and 4 years into the biggest financial instability crisis since the Great Depression, somebody is finally thinking along these lines.
Incidentally, the credentials of the author of that Bruegel piece are perhaps good news:
Guntram Wolff has joined Bruegel from the European Commission's DG for Economic and Financial Affairs. In this position, Guntram worked on the macroeconomics of the euro area and the reform of euro area governance, drafting and coordinating reports to the Eurogroup, the EFC and the Hermann van Rompuy task force on the reform of the governance of the EA and the EU.
Prior to joining the Commission he was an economist in the economics and research departments of the Deutsche Bundesbank focusing on German and EU public finances, sovereign bond markets and macroeconomics of EMU.In the Bundesbank, he coordinated the research team on fiscal policy. Currently he is also an adviser to the International Monetary Fund.
See? German economists associated with the Bundesbank, EU Commission, and IMF are not all insane.
Modern central banks have two main ways of managing liquidity in the financial sector: the discount window and open market operations. Open market operations consist of direct purchases and sales of financial instruments in the open market, and the central bank can use them to tweak asset prices and interest rates in an anonymous way. On the other hand, what the US Fed calls the discount window and the ECB calls main refinancing operations consist of collateralised lending to eligible institutions (banks), which enter into short-term (typically a week) repurchase agreements for eligible collateral. That is, an eligible bank will exchange an eligible asset for cash from the central bank, at a discount or "haircut" (e.g., to lend 100 the central bank may demand that an asset worth, say, 105, be posted as collateral, for a 5% haircut), and agrees to repay the cash (with interest) and recover the collateral after a set period of time. The central bank determines the interest rate of the repos at the discount window, and also the amount of cash available for such lending. In this way, the Central bank can also set interest rates. By setting the "haircut" (discount) on a given asset class, it can also affect the open market prices without actually buying or selling the asset itself.
It should be apparent that the discount window allows the Central Bank to peek into the balance sheets of commercial banks in a way that open market operations don't. When the ECB buys a Greek bond in the open market (obscurely called the "Securities Market Programme" in the last 12 months) it doesn't know who sold it the bond, and even if it does it's immaterial because the bond is now the property of the ECB. However, when the ECB accepts a Greek bond as collateral at the discount window (main refinancing operations in ECB parlance), it knows who holds the bond in their portfolio. The more I think about this the more I hope the Bruegel scholar just made a typo and not a conceptual error when writing his piece.
On the other hand, open-market operations would be appropriate to the Central Bank's function as a market-maker of last resort. Sadly, though, current Central Bank practice has degenerated to the point where all they think they can do is tweak interest rates for uncertain monetarist macroeconomic effects and this through open market operations only. It is certainly a lot easier for the central bank to do things that way: proper regulatory use of the discount window to keep tabs on the commercial banks' balance sheets is a lot more work than to meet once a month in the open market committee and decide to move the target interest rate by a quarter point or not at all, and to buy or sell some bonds, and then get all mysterious at the press conference.
Currently, because of Central Bank over-reliance on open market operations, there is even a stigma attached to banks using the discount window - if a bank taps the discount window, the logic goes, it must be because it cannot fund itself in the money markets. In this way, by under-use of the discount window and over-use of open-market operations, Central Banks have managed to lose their single most important supervisory tool to assess the quality of bank balance sheets. If the ECB really cared about financial stability, it would greatly increase bank reserve requirements while providing unlimited liquidity (at asset-appropriate discounts) at the weekly refinancing operations, and it would use open-market operations for market-making of last resort.
Unfortunately, the odds of the ECB taking financial stability seriously in the near future are slim. As evidence, take the fact that
the German chancellor wants to extract substantive concessions for supporting the Italian central bank governor [Draghi for ECB president]. ... Secondly she wants Jens Weidmann, who is officially inaugurated as the Bundesbank president today, to succeed to Draghi as the chairman of the Financial Stability Board (FSB).
together with Jens Weidmann's words
at his own inauguration as Bundesbank President:
While acknowledging that financial stability had become an important aim for central banks after the crisis he stressed that the primary goal remained pri[c]e stability. “On this point there must not be any compromises for central banks”, he stressed.
Whoa, and then what does he think of unlimited liquidity at the discount window?
According to Weidmann the crisis had created the wrong incentives and therefore the exit from the special measures and the normalisation of monetary policy remains a priority.
Not good at all. And then, to top it all up
Wolfgang Proissl takes a look at Jens Weidmann, and concludes that he will be the most important central banker in Europe next to the ECB’s new president, due to Germany’s relative weight in the ECB, but also the over-representation of southern Europeans in the ECB executive board (though this will change if Lorenzo Bini Smaghi were to step down). ... He says Weidmann was already the strongest candidate for the succession of Draghi in eight years time.
Without further ado, let me now bore you with the turgid writing
of Hyman Minsky 25 years ago:
If the Federal Reserve acts as a normal-functioning supplier of funds to banks through the discount window, then as long as banks value this source of funds they will conform to business and balance-sheet standards set down by the Reserve banks. On the other hand, if Federal Reserve credit is supplied to banks by means of open-market operations in government securities, then the customer relationship between a member bank and the Federal Reserve loses its power to affect member-bank behavior. The power of the Federal Reserve to affect member-bank behavior through normal banking relations was much diminished after World War II. This diminution of Federal Reserve clout, to use a concept drawn from Chicago politics, was not offset by an increased sophistication of Federal Reserve examination and regulation of banks. [pp. 52-53]
Commercial bank reserves mainly result from the ownership of government securities by the Federal Reserve. The government security/open market technique of supplying reserves to the banking system is not the only way reserves can be furnished. Prior to the Great Depression, a major part of reserves that were not based on gold were based on borrowings by banks at the discount window. The resurrection of the discount window as a normal source of bank reserves is a way of tightening Federal Reserve control over commercial banks. If commercial banks normally borrow at the Federal Reserve discount window, they will necessarily accept and be responsive to guidance by the Federal Reserve [p. 282]
If bank reserves are largely the result of discounting short-term paper tied to the ownership of business inventories, then as loans fall due and are repaid bank reserve balances fall. To bring reserves to target levels, banks would have to discount paper and there would be a continuing business relation between banks and the Federal Reserve. Thus, a major necessary reform [for financial stability] is for the federal reserve to shift from the open-market technique to discounting. The discount window method for creating the reserve base induces favorable terms for the hedge [non-speculative, non-ponzi] financing of short-term positions and blunts the tendency towards fragile financing structures. [pp. 361-2]
(All references to page numbers of the 2008 hardcover edition by McGraw-Hill of Stabilizing an Unstable Economy