The Federal Reserve's Liquidity Facilities - FEDERAL RESERVE BANK of NEW YORK
Speech
The Federal Reserve's Liquidity Facilities
April 18, 2009
William C. Dudley
, President and Chief Executive Officer
Remarks at the Vanderbilt University Conference on Financial Markets and Financial Policy Honoring Dewey Daane, Nashville, Tennessee
Thank you for having me here today. It is a great honor to be
on a panel with Peter Fisher and Bill Poole. I am the neophyte here in
terms of central banking experience!
Before I begin, let me emphasize that my comments represent my own views
and opinions and do not necessarily reflect the views of the Federal Open Market
Committee or of the Federal Reserve System.
I am going to talk today about the
Fed’s provision of liquidity to banks
and dealers and to market participants more generally.
I would break down our actions into three broad classes.
First, we addressed the acute seizing up of inter-bank financing markets. For
banks, we introduced the Term Auction Facility in December 2007 and for the
primary dealers, the Term Securities Lending Facility and Primary Dealer Credit
Facility in March 2008. In addition, the Federal Reserve entered into
FX swap agreements with major global central banks in order to channel dollar
liquidity to banks overseas.
Second, we expanded our provision of short term
financing beyond banks and dealers in order to alleviate constraints on highly
rated corporate borrowers. The
two most noteworthy examples of this are the Commercial Paper Funding Facility,
which was introduced in October 2008, and the Term Asset-Backed Securities
Lending Facility (announced in November 2008, but not up and running until
last month.)
Third, once
policy rates were near the zero-bound, we expanded the type of assets that
the Fed purchased. In order to put downward pressure on general
longer term borrowing rates, particularly mortgage rates, the Federal Reserve
has purchased the debt of the GSEs, namely, Fannie Mae and Freddie Mac
and the mortgage-backed-securities they issue, and, more recently, longer-term
Treasuries.
So why has the Fed done so much in terms of special programs?
As I see it,
there are four major reasons behind the dramatic expansion of the Fed’s
liquidity programs:
To provide liquidity to banks and dealers in order to slow down the deleveraging
process.
To expand the balance sheet capacity of the private sector to counteract
the shrinkage underway in the non-bank financial sector.
To restore and improve market function.
To ease financial market conditions.
This financial crisis has been marked by the rapid deleveraging of the non-bank
financial sector. This deleveraging has been driven mainly by the collapse
of securitization activity, pressure on dealers to reduce leverage and the
spillover of these efforts on to other financial players such as hedge funds.
This deleveraging process, in turn, has put intense pressure on the balance
sheet capacity of the banking sector. Not only can banks no longer securitize
assets as before, but assets that they thought were off their books have come
back on.
Although the deleveraging process is inevitable following periods when the
financial system has become overextended, it does matter how this deleveraging
process takes place. In the current crisis, the deleveraging process
at times has been very violent and dangerous, with powerful reinforcing feedback
loops intensifying the process. During these episodes, bystanders who
did not engage in excess may be trampled and fail. This may exacerbate
the tightening in financial conditions, intensifying the constraint on credit
availability and the downward pressure on economic activity.
For example, in
March 2008, in the run-up to Bear Stearns’ demise, the
deleveraging process intensified. Market volatility increased;
this caused lenders to increase the haircuts they assessed against collateral
to secure their lending. The higher haircuts, in turn, squeezed highly
leveraged investors who were forced to sell assets. This drove down asset
prices and increased price volatility further, leading to still-higher haircuts.
This intensified the deleveraging process, which led to more mark-to-market
losses.
The Federal Reserve’s facilities for banks and dealers have
been designed, in part, to slow down the deleveraging process. The TAF, the
TSLF and the PDCF have provided assurance to banks and dealers that they have
a place where they can obtain funding for their less liquid collateral. As
a result, they will not be forced to dump assets, further depressing market
prices, increasing volatility and the upward pressure on haircuts. The deleveraging
will still take place—and we have seen it—just not so quickly and
violently that it would destabilize the entire financial system.
The second
major intent of the liquidity facilities has been for the Fed to expand its
balance sheet and, by doing so, offset some of shrinkage that has been occurring
among non-bank financial intermediaries. The fact is the banking system is
capital-constrained, with insufficient capital to expand its balance sheet
fast enough to offset the shrinkage evident in the non-bank sector. Although
the Federal Reserve cannot create capital for banks, it can provide funding
directly to the private sector, attenuating the consequences caused by a balance-sheet-constrained
banking system.
The CPFF and the TALF are both important in restoring the flow
of credit to borrowers. The CPFF essentially jump-started the commercial paper
market, which had largely shut down following the failure of Lehman Brothers
in September.
The TALF’s purpose is to restart the securitization markets, and thereby
lower the cost of borrowing to households and business. The TALF does
this by providing term, non-recourse loans to investors against AAA-rated collateral.
Investor demand for these loans leads to downward pressure on AAA-rated financing
rates, lowering the cost of credit. Although TALF is off to a relatively slow
start—hurt, in part, by the reluctance of some investors to participate
because of worries about the potential implications for them of the TARP funding
that is involved in the TALF program, it has helped to restart the securitization
markets in the consumer asset-backed securities area and has brought down funding
costs for consumer ABS issuers.
The third goal of these policy interventions
has been to improve market function. By dramatically reducing rollover risk,
the Federal Reserve’s willingness
to serve as the lender or investor of last resort has helped improve market
function in a broad number of areas. Rollover risk is the risk that a
borrower may not be able to obtain new funding in order to repay an investor
when the investor needs the funds for other uses. If rollover risk is high,
the investor is going to be concerned about getting its funds back and, thus,
may be unwilling to make the investment in the first place. The impact
of the Fed’s intervention on rollover risk has been especially important
in the triparty repo market and in the commercial paper market.
The triparty
repo market is a market in which investors such as money market mutual funds
lend funds, mostly on an overnight basis, to securities dealers, with the loans
collateralized by high-quality securities. During the crisis, this market became
less stable. As the financial condition of some of the major securities dealers
worsened, the clearing banks became more reluctant to return the cash that
the triparty repo investors had invested the prior evening. The clearing banks
were worried that if a dealer were to fail, they could be stuck with a large
obligation. The nervousness of the clearing banks, in turn, spilled back to
the investors. If there is some chance that I might not get my cash back and
instead be stuck with the collateral, do I really want to make the loan in
the first place? The Primary Dealer Credit Facility essentially broke this
dynamic by putting the Federal Reserve in the position of lender of last resort
in the triparty repo system. With the Federal Reserve willing to lend against
collateral, the clearing banks no longer have significant intraday risk exposure.
The triparty repo investors have been reassured that they would be paid back.
As a consequence, they were willing to keep investing.
The TAF and the dollar
facilities offered by foreign central banks provided the same antidote to rollover
risk in the interbank funding markets. Banks that were reluctant to lend to
one another because of rollover risk became willing to reengage because they
knew that the Federal Reserve and foreign central banks would lend against
high-quality collateral.
By eliminating rollover risk, the CPFF also helped to restore market function
in the commercial paper market. Commercial paper investors who
had shunned the market returned because they were no longer worried that they
could get their money back. In extremis, the Federal Reserve could purchase
the commercial paper from the issuer, generating the funds to repay the private
investors’ commercial paper investment.
The fourth and final goal of
the Fed’s liquidity facilities has been
to ease financial conditions. This has been particularly important in
the current environment because the federal funds rate cannot be pushed below
zero (the so-called zero-bound constraint). This means that with the
federal funds rate having been effectively lowered as far as it can go, the
Federal Reserve has had to turn to other tools such as asset purchase programs
if it is to ease financial conditions further as warranted given macroeconomic
conditions.
The Federal Reserve’s purchases of agency debt, agency MBS
and longer-term Treasuries have been implemented mainly with one goal in mind—reduce
longer-term private sector interest rates, and thereby provide stimulus to
the U.S. economy.
The Federal Reserve’s Treasury purchase program is designed to hold
down the level of longer-term interest rates. To the extent that a lower
level of long-term Treasury rates pulls down the level of private long-term
rates, then these purchases should also ease financial market conditions.
So how have the Fed’s facilities worked in practice?
In general, I
think the facilities have worked quite well. In those areas where the facilities
have been active, we generally have seen an improvement in market conditions.
But the facilities have not been a panacea for three reasons. First, the facilities
cannot address the fundamental problem—the shortage of
capital in the banking system. The facilities can slow down the deleveraging
process, but until the banking system is viewed as being sufficiently well-capitalized
and is able to expand its lending activity significantly, the limits on credit
availability caused by an impaired banking system will make it more difficult
to generate a sustainable economic recovery.
Second, there are limits on what
the Fed can do legally. For example, the Fed can only lend if it is secured
to its satisfaction. There has to be sufficient collateral available. The Fed
cannot lend on an unsecured basis or provide guarantees. And the Fed cannot
purchase assets other than Treasuries, agencies and agency MBS, and short-dated
general obligations of states and municipalities.
Third, the effectiveness
of some of the Fed facilities have been undercut by stigma—the discount
window is the best example of this—or by worries
about what other strings are or might be attached to the use of the facilities—the
TALF comes to mind in this respect.
One reason why the TALF has gotten off
to a relatively slow start is the reluctance of investors to participate. Issuers’ interest,
not surprisingly, dwarfs investor demand at this stage of the program. Some
investors are apparently reluctant not because the economics of the program
are unattractive, but because of worries about what participation might lead
to. The TARP loans to banks led to intense scrutiny of bank compensation practices
given that TALF loans are ultimately secured by TARP funds, investor anxiety
about using the program has risen.
My own view is that these fears are misplaced.
The TARP funds in the TALF program only come in on the backend of the program
when loans are put back to the Fed. The lending to investors on the front end
is completely a Federal Reserve program and operation. That being said, I understand
the reasons for the anxiety given the political discourse on this subject.
I think it is worth emphasizing that actions that lead investors to shun taking
risk, especially in this environment, are ultimately detrimental to the ability
of households and businesses to secure credit at reasonable borrowing rates.
The
Federal Reserve’s liquidity facilities and asset purchase programs
have led to a substantial expansion of the Federal Reserve’s balance
sheet since September 2008. Currently, the Fed’s balance sheet totals
about $2.2 trillion, up from about $900 billion last fall prior to Lehman’s
failure.
In thinking about this balance sheet expansion, I would make three broad points.
First, in my mind, the goal is not the expansion of the balance sheet per se,
but the objectives that I laid out earlier. In this respect, the expansion
of the balance sheet differs considerably from Japan’s experience with
quantitative easing. In the current circumstance, the Federal Reserve’s
liquidity programs act on the asset side of the balance sheet as the Fed lends
funds against less liquid collateral and expands its asset holdings via purchases
of agency debt, agency MBS and Treasuries. The goals are to slow down
the pace of deleveraging to reduce the risk of catastrophic failure, improve
market function and ease financial market conditions.
In contrast, the Bank
of Japan worked on the liability side of the balance. Their goal was to expand
the amount of excess reserves held by the banking system so that the banks
would be more willing to expand their credit provisions. Although the Fed’s
activities have led to a big jump in excess reserves, this increase is incidental—a
byproduct rather than goal of the asset-oriented programs.
Second, as a consequence
of this my point, the size of the balance sheet, is not a good metric for measuring
the impact of the Fed’s facilities or
the amount of stimulus that the Fed is providing via these programs. For
example, consider the impact of the Fed facilities on rollover risk. A
Fed facility that eliminates rollover risk might not be used at all. There
might be no balance sheet impact. Nevertheless, the facility could have
an important impact on market function and financial market conditions.
It
is not possible to mechanically map the size of the balance sheet back onto
the impact on financial market conditions. That is because the balance
sheet size is being driven by a large number of different actions. Is
a dollar of TAF lending equivalent to a dollar extended through the CPFF or
to a dollar of Treasury purchases? How important is the PDCF? It
backstops lots of lending, but outstanding amounts are very low. The
differences between the various programs and activities mean that the balance
sheet size should be interpreted in light of the impact on market function
and financial market conditions, not by the impact on the size of the balance
sheet.
The size of the balance sheet is also not a good standard because the
use of the different facilities depends on the degree of impairment in market
function. If market conditions were to deteriorate, I would expect that usage
of the Fed’s
facilities would increase and the balance sheet would grow in size. This
would be appropriate. The Fed’s balance sheet would act as a shock
absorber, cushioning the impact of the shift in market conditions. In
such circumstances, the balance sheet would act as a counter-cyclical dampening
mechanism. I would view that as a desirable outcome.
In contrast, if the
Fed were committed to a particular balance sheet trajectory, then, as market
conditions improved and financial conditions eased and usage of the Fed’s
liquidity facilities diminished, the Fed would have to offset this by increasing
the scope of its liquidity facilities or by expanding its asset purchase programs.
It is unclear to me why the Federal Reserve would want to apply more stimulus
at a time when market conditions were improving. This suggests that some variability
in the trajectory of the Fed’s balance
should be expected and might even be desirable. And, in fact, this is
what we have seen in practice.
Third, I am not worried at all that the Federal Reserve’s balance sheet
expansion will generate an inflation problem. It should be emphasized
that the Federal Reserve has the ability to manage down the size of its balance
sheet over time once financial conditions and the economy improve. Many
of the liquidity facilities will shrink automatically as financial conditions
normalize. With the exception of TAF loans, all of the other Fed liquidity
facilities charge rates that are higher than what one would expect during more
normal financial circumstances. And, if we want the TAF loans to shrink,
we can either shrink the amounts on offer or raise the interest rate we charge,
or both. The other assets such as Treasury securities and agency MBS
can be sold or the impact on reserves be offset by repurchase operations that
drain reserves from the banking system.
More importantly, the Federal Reserve
now has the tools to allow the conduct of monetary policy to be separated from
the size of the balance sheet and the amount of excess reserves in the banking
system. In September 2008, the Federal Reserve gained the authority to pay
interest on excess reserves. This provides a tool that allows Fed officials
to tighten monetary policy and raise private sector interest rates by raising
the rate paid on excess reserves.
Some skeptics note that when interest on
excess reserves was first implemented, the federal funds rate traded somewhat
below the rate on excess reserves. This has created worry in some quarters
that paying interest on excess reserves might not work very well as a tool
for controlling the federal funds rate.
On this issue, two points are warranted.
First, the relatively large gap between the interest rate on excess reserves
and the federal funds rate was due, in large part, to the impaired condition
of the banking system, which inhibited the willingness of banks to arbitrage
that gap. Because balance sheet capacity was scarce, banks were reluctant to
use their balance sheets to purchase federal funds at a slight discount to
the interest on excess reserves rate. As the banking system returns to health,
this arbitrage is likely to become more attractive, causing the gap between
the interest rate on excess reserves and the federal funds rate to narrow.
Second, the Federal Reserve could alter its monetary policy framework in order
to increase its control of monetary policy in a large excess reserve environment.
It is beyond the scope of this speech to get into the details, but we have
plenty of options in devising incentives for banks to hold reserves at the
Fed that would improve our ability to control the federal funds rate. The challenge
will be deciding on the best option, not in finding a workable approach.
Thank
you for your attention.
I am happy to take any questions.
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