What’s the best way for central banks to provide liquidity?
One of the most acute problems experienced by developed countries
since 2008 is that the expansion of the monetary base has not been
matched by an expansion of credit to economic activity. In January 2015
loans to the private sector were still contracting in the euro area,
despite a steady increase in the money supply. The long-lasting
contraction of credit has particularly hit small and medium-sised
enterprises (SME), which have often found themselves exposed to
rationing. The question of how to repair the transmission channel has
therefore naturally emerged. Given the malfunctioning of bank lending
channels, should central banks find alternative strategies for easing
SMEs’ access to credit?
The limits to collateralised lending
One possible solution involves designing better mechanisms for
securitising small corporate debt – once turned into standardised
collateral, SMEs’ highly idiosyncratic debt could thus be made eligible
to central bank operations (e.g., see Brunnermeier and Sannikov 2014).
By intervening directly on the asset-backed corporate securities market,
central banks could in this way bypass the banking system. This would
not actually imply any major change in monetary policymaking for major
central banks, who engage exclusively in collateralised operations
today. As recent experience and theoretical developments have shown,
however, the big problem with standardised collateral is that it is
constructed precisely in order to allow lenders to save on
information-gathering costs. As a result, the price of standardised
collateral tends to be prone to informational shocks, which can easily
trigger money market freezes (Gorton and Ordoñez 2014). In such
circumstances, the only way a central bank can prevent the freeze of a
collateralised loan market is by transforming itself into a
‘market-maker of last resort’ – clearly a suboptimal outcome (Buiter and
Sibert 2007). All this suggests that collateralised loan markets might
not necessarily be an ideal intervention ground for central banks –
especially when the risk of a ‘collateral shock’ is highest. An
alternative might consist of going the opposite way – rather than
operating on a standardised collateral debt market that incites
participants not to collect information, the central bank could operate
on an uncollateralised debt market that does incite participants to rely
on valuable information.
Two concepts of liquidity
Uncollateralised and collateralised lending can be associated to two
different concepts of liquidity, corresponding respectively to today’s
definitions of liability-side (funding) liquidity, i.e. the ease with
which funding can be obtained; and asset-side (market) liquidity, i.e.
the ease with which a given asset can be sold (Holmström and Tirole
2010). In some scholars’ view, these two concepts of liquidity are but
the two sides of the same coin (e.g., see Brunnermeier and Pedersen
2009) – but this applies only if liability-side liquidity can be
exclusively obtained through collateralised loans, access to which is
proportional to available collateral. This is not necessarily always the
case, though – when uncollateralised transactions are easily available,
funding and market liquidity are not bound to behave accordingly. The
reason is that uncollateralised operations may involve other kinds of
(moral) guarantee (Ghatak and Guinnane 1999). This suggests that the two
concepts do not perfectly coincide. The fact that the central bank
chiefly provides the one or the other type of liquidity will provide
different incentives to information-gathering by money market
participants.
Central bank liquidity provision during the first globalisation
In a recent paper, we reconstruct the way central banks’ liquidity
provision has evolved over the last two centuries (Jobst and Ugolini
2014). We find that uncollateralised operations were long-preferred to
collateralised ones as a means for providing liquidity to the economy –
the share of collateralised operations in total lending constantly
declined from the end of the Napoleonic wars to the mid-19th century,
and recovered substantially only in connection with the world wars.
Although the situation differed from one country to the other,
uncollateralised loans were thus predominant everywhere in the period
between these two major geopolitical shocks (see figure 1). Therefore,
during the first globalisation central bankers appeared to prefer
uncollateralised over collateralised operations. Why was that the case?
Figure 1. Share of collateralised operations in total domestic lending (averages per decade)
Source: Jobst and Ugolini (2014). The database includes ten
countries (Austria, Belgium, Switzerland, Germany, France, Italy,
Netherlands, Norway, UK, and US). For individual country data, see table
2 in the paper.
Note: Each central bank is one observation. Boxes cover observations
between the first and third quartile (inside line being the median),
whiskers cover the remaining observations except outside values. Outside
values (smaller/larger than the first/third quartile less/plus 1.5
times the interquartile range) are plotted individually.
19th century central bankers’ bias for uncollateralised operations
The extent to which central bankers engage in one of the two
interventions may be related to the credit risk associated with each
type of operations. In principle, thanks to the double guarantee
provided by the borrower and by the collateral, secured transactions
should be less risky – in particular if the collateral consists of
easily marketable government securities and haircuts are significant.
However, unsecured lending through the purchase of commercial bills (the
standard 19th century discount operation) also benefitted from the
additional safety feature provided by the joint moral guarantee of all
persons (at least two) who had signed the bill. Unlike marketable
securities, moreover, bills were subject to credit risk but not to
market risk, as their price at maturity was not liable to vary. As a
result, none of the two types of operations was necessarily superior to
the other as far as risk is concerned.
Commentators unanimously report that discounting of uncollateralised
(but jointly-guaranteed) commercial bills was clearly preferred in the
19th century:
- Discounting was deemed to provide more flexibility for the
adjustment of overall liquidity. Continuous backflows from bills falling
due could facilitate the granting of new loans to new counterparties,
which was useful whenever money markets were not working perfectly.
Central banks might have been forced to prolong collateralised loans, or
face difficulties selling the collateral. Bills, on the other hand,
were considered to be ‘self-liquidating’, a widespread notion in
19th-century banking (Plumptre 1940). The same concern about liquidity
can also explain the preference of many central banks for real bills
over finance bills, as finance bills (with their need to be rolled over
at maturity) rather resemble collateralised loans in moments of
financial stress.
- It was possible to derive valuable information on economic activity
from the bills submitted to discount. Central banks were big players in
the money market. For instance, around 1900 40% of all bills originated
in France each year passed through the Banque de France’s discount
window (Roulleau 1914). Central bankers were hence necessarily concerned
about financial stability, and the discounting of bills was thought to
provide the possibility to manage the extent of risk-taking in the
economy, because the origination and distribution of bills were possible
to track (Flandreau and Ugolini 2013). Moreover, by encouraging or
discouraging the presentation of certain types of bills for discounting
at its discount window, central banks could encourage or discourage
particular activities or sectors (Allen 2014).
The 20th century change
Central bankers’ attitude seems to have changed following the
crowding-out of the commercial bill market by the government debt
market, engendered by the world wars. The costly information-gathering
mechanisms put into place in order to monitor risk-taking in the bill
market became less and less useful, and central bankers gradually
started to dismiss them. This prompted a rethinking of the concept of
liquidity, which became closer to the modern one – according to which
asset- and liability-side liquidity are but two sides of the same coin
(Plumptre 1940, Brunnermeier and Pedersen 2009). Today, central bankers
no longer focus on the maturity of outright holdings (i.e., their being
self-liquidating) but on the possibility to sell them on the market if
need be (i.e., their ‘shiftability’). Shiftability, however, appears to
be very sensitive to informational shocks (Gorton and Ordoñez 2014). As a
result, central banks have increasingly found themselves exposed to
collateral crises – and hence, to the risk of having to become
market-makers of last resort.
Concluding remarks
Unlike their 19th century predecessors, today’s central banks no
longer try to have access to superior information than markets – as any
other market participant, they rely on the informational shortcuts
provided by collateralisation. As a result, central banks appear to be
fatally doomed to become market-makers of last resort whenever
informational shocks trigger the unravelling of collateral crises. An
alternative might consist of reviving 19th century practice and
reactivating uncollateralised lending, thus encouraging all market
participants not to rely on informational shortcuts. This might perhaps
provide a more efficient strategy in order to repair the transmission
channel. Sure, the costs of rebuilding information-collection mechanisms
might well be substantial; but economies of scope must exist between
monetary policy implementation and the carrying-out of the financial
stability mandate.
References
Allen, W (2014) “
Eligibility, bank liquidity, Basel 3, bank credit and macro-prudential policy: History and current issues”, Working Paper.
Brunnermeier, M and L Pedersen (2009), “Market liquidity and funding liquidity”, Review of Financial Studies, 22(6): 2201-38.
Brunnermeier, M and Y Sannikov (2014), “
Repairing the transmission of monetary policy through asset-backed securitisation”, VoxEU.org, 3 June.
Buiter, W and A Sibert (2007), “
The central bank as the market maker of last resort: From lender of last resort to market maker of last resort”, VoxEU.org, 13 August.
Flandreau, M and S Ugolini (2013), “
Where it all began: Lending of last resort and Bank of England monitoring during the Overend-Gurney Panic of 1866”,
in M Bordo and W Roberds (eds), A return to Jekyll island: The origins,
history, and future of the Federal Reserve, Cambridge University Press,
2013, 113-161.
Ghatak, M and T Guinnane (1999), “The economics of lending with joint
liability: Theory and practice”, Journal of Development Economics, 60:
195-228.
Gorton, G and G Ordoñez (2014), “Collateral crises”, The American Economic Review, 104(2): 343-378.
Holmström, B and J Tirole (2010), Inside and Outside Liquidity, MIT Press.
Jobst, C and S Ugolini (2014), “
The coevolution of money markets and monetary policy, 1815-2008”, European Central Bank Working Papers Series no. 1756.
Plumptre, A (1940), Central banking in the British dominions, University of Toronto Press.
Roulleau, G (1914), Les règlements par effets de commerce en France et à l’étranger, Société de Statistique de Paris.
This article is published in collaboration with Vox EU. Publication does not imply endorsement of views by the World Economic Forum.
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Author: Clemens Jobst is an Economist at the Oesterreichische
Nationalbank, Research Affiliate at CEPR. Stefano Ugolini is an
Assistant Professor of Economics, University of Toulouse.
