Wednesday, 23 May 2012

Singh And Stella on Collateral

A recent paper by Manmohan Singh and Peter Stella for the IMF Research Department (blogged version here) makes an interesting contribution to begin by questioning the money multiplier – one of the key concepts concerning how central banks are supposed to work.

Traditionally, they point out, “credit and money are [considered] counterparts to each other on different sides of the balance sheet”: banks create credit backed by the ‘base money’ which they hold as currency or deposits with the central bank. The money multiplier is the ratio of total monetary liabilities in the economy (the loans extended by the banking system) divided by the monetary base. With bank notes removed from the equation leaving only the ‘liquid reserves’ which banks have deposited with the central bank, the adjusted money multiplier is considered to provide a measure of the performance (or risk) of the commercial banking system in providing credit to the economy.

Through their ability to create or withdraw these reserves of base money by buying and selling financial assets from commercial banks (known as ‘open market operations’) the central banks are commonly considered to control a ‘transmission mechanism’ which determines the money multiplier. To increase the supply of money in the economy, the central bank can buy financial assets from commercial banks in exchange for liquid central bank deposits, which should provide the basis for increased lending both between commercial banks and into the wider non financial economy (the exact quantity of which should be predictable through algebra): QE has essentially been this carried out on a vast scale, and it is why many financial commentators assert that the measures will inevitably create hyperinflation. 

The paper challenges these notions, firstly by pointing out the by now well known fact that in the decades leading up to the financial crisis, the total amount of credit in the US economy increased far faster than the creation of new central bank deposits (see figure 2). Why? Only commercial banks can hold deposits at the central bank, but as the authors point out over the past 30 years the shadow banking system “has accounted for almost the entire growth in US financial deepening”. How? Though the use of liquid assets to be used in collateralized borrowing: highly rated securities can be used again and again as collateral for the creation of new loans in a process called re-hypothecation, and the increased use of securitization created a range of new alternative liquid assets to be used by the shadow banking system to create loans.

Distinctions need to be made between different types of collateral. On the one hand there is high quality collateral in the form of bonds issued by solvent sovereign governments, which can be used in credit creation almost anywhere. Other kinds of securities can be used as collateral under normal market conditions (and their use grew enormously in the run up to 2008) but they lose their utility in this regard in a downturn when markets begin to doubt their value. This happened most spectacularly with securitized housing market assets, resulting in a system wide liquidity crisis as interbank lending seized up.

The real fulcrum of liquidity creation, they argue, is to be found in the market practices relating to judgements of which assets are ‘acceptable collateral’ rather than with the central bank officials executing conventional monetary policy. Since the crisis, this has been reflected in two phenomena. Firstly, there has been intense demand for safe assets to use as collateral – hence the low price of UK and US government borrowing despite their indebtedness. Secondly, despite the unprecedented creation of new reserves at the Fed, there has been no corresponding increase in inflation (see table 1).

Since the crisis, chains of re-pledging have shortened from 3 steps in 2007 to 2.4 at the end of 2010, while the total volumes of re-pledged collateral have fallen from $10 trillion in 2007 to $5.8 trillion at the end of 2010. The actions taken by central banks in expanding their balance sheets has not, the authors suggest, been sufficient to make up for these losses: conventional QE substituted central bank deposits for high quality collateral that would have been re-pledged for collateralized borrowing, meaning that QE had nothing like the lubricating effect on the financial system that would have been anticipated under a conventional money multiplier view.

The banks’ liquidity crisis continues and, as the authors note
Unless there is some rebound in the pledgeable collateral market (by either an increase in ‘source’ collateral, or its velocity or re-use rate), the likely asymmetry in the demand and supply of good collateral may entail some difficult choices for the markets and the regulators.

Difficult choices such as whether a return to pre-crisis levels of global liquidity is even possible, let alone desirable.

Monetary policy is in uncharted territory and, they argue, as assumptions about the relative importance of the transmission mechanism against the role of collateral are revised, swapping bad for good collateral may now become a routine activity of central banks. This carries with it questions of risk and accountability which make the independence of central banks from democratic accountability seem more problematic than ever.

On Central Banks

One of the most remarkable (but so far least remarked upon) features of the ongoing financial crisis is the role which has been played by central banks. With governments either unwilling or unable to address the problems of the financial system through regulation and the problems of the wider economy through fiscal measures, responsibility for both mitigating the crisis and engineering the recovery has been quietly seized by central banks. 

The ECB has been credited with (if only temporarily) pulling the European banking system from the edge of collapse through the injection of over a billion of Euros of liquidity via the Long Term Refinancing Operation (LTRO). The Bank of England and U.S. Federal reserve have similarly been cast as heroes for their quantitative easing (QE) programmes – the Bank of England’s, which began in March 2009, has involved a commitment to £325 billion worth of asset purchases in an effort to ease credit creation in the banking system. The Fed’s successive QE programmes took the value of its holding s of Treasury Notes up from $800 billion pre-crisis to over $2 trillion in less than two years. Central bank balance sheets have grown explosively.

Via Financial Times
These actions are remarkable not simply because of the sums of money involved, but because of the divergence it marks from the script which central banks are supposed to follow in modern capitalism.
The script, written during the 1980s and implemented in the 1990s, in heavily truncated form goes roughly as follows: central banks operate primarily to safeguard monetary stability, targeting price inflation via control over short term interest rates. The economic importance of monetary stability is such that the central banks should be granted independence from political interference, and allowed to function as politically neutral technocracies acting in the general interest.

Central banks time honoured role in disaster control as a lender of last resort to commercial banks and a guardian of overall financial stability was considered to be obsolete given the advances in risk-reducing financial innovation. New institutions such as the Financial Services Authority in the UK were formed to unburden central banks of this regulatory duty. These new institutions addressed risk on the micro level of governance in individual firms, while both the Fed and the BoE drastically cut back on the attention devoted to systemic financial stability issues. Mervyn King’s disdain for the Financial Stability Committee made it a “running joke” within the BoE according to one insider quoted by the FT.

Events of the past four years have meant that the script has been thoroughly torn up: in an era of LTRO and QE central banks have a far wider range of duties and a wider range of tools with which to carry them out. By keeping a terminally ill banking system on life support and in the UK and EU providing backing for controversial austerity measures, they have become unaccountable political actors rather than neutral technocrats.

In a conjuncture which could be described as central bank led capitalism, ambiguity surrounds the issue of what central banks have become and what they should be, and a number of questions present themselves.

1)      Firstly, what function do central banks now perform? There is a need to address this simplest of questions on both a technical and a political-strategic level; the former because the operations of central banks, or at least the discourses used to articulate them, are esoteric, and the latter because in both the long and the short term, the end goals of recent central bank actions could be interpreted in a variety of ways.
2)       Secondly, how effective have the recent actions taken by central banks been? Or rather, if this is now a central bank led capitalism, how well are they able to lead? Popular representations of the central banks and central bankers of late have tended to present them as reluctant hero figures (e.g. Ben Bernanke as Time Magazine person of the year 2009) capable, to borrow David Cameron’s phrase, of wielding ‘the big bazooka’ and breaking the negative feedback loop of financial collapse once other measures have failed. Does this all powerful image fit reality?
3)      Thirdly, was ‘the script’ ever that useful a way of understanding central banks, or does the common historical account of their role and capabilities need a revision in light of recent events?

Over the coming weeks, this blog will make an attempt to address some of these questions by way of a dialogue.