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Category Archives: Global liquidity

On Covered Bonds, Collateral Crunches, And The Circular Logic Of Central Banks

This post by Zero Hedge gives a subjctive interpretation of the current rush of covered bonds by Europeans banks, some of them soon approaching the limits for such issuance. Many banks retain large portion of the new bonds themeselves; which raises the interesting question if you can own your own debt!

The post goes on to argue that central banks are painting themeselve into a corner, where lack of collateral and requirement of collateralized lending (from CBs to banks) will finally meet.

If, however, the covered bond bridge is pushing up against its very real statutory and quality limitations, that might mean the ECB is now fighting a two-front funding war – retail deposit flight and collateral diminishment at the same time. 

At that point the system will collapse or central bank will be force to relax collateral requirements, ref. Tuckers discussion of this problem under the heading of “central banks’ time inceonsistency problem”, for a discussin of this dillemma see my Levy WP here on The Collateral Squeeze, p. 17

Alternatively (and better), central banks should let failing banks go into resolution and stop the collateral chasing. Better to start on this process before it becomes too late.

The neglected part of international financial reform: Liquidity regulation | vox

This Vox post by Stefan Schmitz from the central bank of Austria, is quite interesting. He describes the current back-peddaling on the liquidity regulation by key policy makers and argue strongly that the regulation should be implemented as planned.

If this collides with a shortage of safe assets, banks should reduce their short-term net cash outflows (p. 6)

This mismatch between the need for safe assets and the growing size of the financial (trading) sector is something I dealt with in my Levy WP 712: Shadow banking and the limits of central bank liquidity support.

It will indeed be interesting to see how the this regulatory fight will be influenced by the ongoing crisis.

Shadow banking and central bank liquidity support

Global liquidity provision is highly pro-cyclical. The recent financial crisis has resulted in a
flight to safety. Severe strains in key funding markets have led central banks to employ highly unconventional policies to avoid a systemic meltdown. Bagehot’s advice to “lend freely at high rates against good collateral” has been stretched to the limit to meet the liquidity needs of dysfunctional financial markets.  As the eligibility criteria for central bank borrowing have been tweaked, it is legitimate to ask how elastic the supply of central bank currency should

I address this question in a new Working Paper from Levy Institute: Shadow banking and the limits of central bank liquidity support. The paper review the recent expansion in central bank liquidity support, including their collateral polices, and then suggests that central banks should not unconditionally supply liquidity to a banking system that is growing uncontrolled. Stricter controls are required unless central banks again will have to underwrite dysfunctional markets.

The paper also provides input to the ongoing Krugman – Keen discussion on banking. See especially section 6 on excessive global credit and section 7 on A new view of banking.

Shadow banking in all channels

Shadow banking was the theme of a recent speech by FSA chairman Adair Turner. He noted in the Cass Lecture 2012 that (p. 21)

“the shadow banking system can create forms of ‘private money’ held either by the non-financial real economy or by intermediate financial institutions, in a fashion analogous to the banking system’s own creation of deposit money. And wherever there is maturity transformation and private money creation, there is a potential for runs. 

And to … make the banking system safe we will need to control the extent to which banks can provide such liquidity insurance to shadow banks. 

A key issue is whether shadow banks should be regulated as ordinary banks, and specifically whether they should have access to central bank liquidity facilities. Here the views are split among academics and policy makers.

The EU has issued its own Green paper of shadow banks and will host a conference on the topic end of April.

The IMF held a conference on the data needs of supervising shadow banks last fall: Casting Light on Shadow Banking: Data Needs for Financial Stability. The video is quite interesting, especially Paul Tucker from BoE, as usual very to the point.

The IMF hosted another regulatory seminar last friday March 23 (same time as the Fed conference, se previous post) on “The Financial System Five Years from Now”. No papers on the web yet, but program is posted here. Seems like an interesting day, with Buiter, Tarullo, Boot and Blanchard.

An interesting paper on Shadow banks posted last fall on the Harvard Law School Forum, called Shadow Banking and Financial Regulation. Short and to the point.

And there will be more coming. G20 and FSB has shadow banking (together with liquidity and trading book) on their agenda this summer, so expect much more on shadow banking in the months ahead.

And, if you want to really know what to do with the shadow banking problem, there will be a good working paper coming up shortly on the Levy Institute’s website. Should be up some time early April. Title: Shadow banking and the limits to central bank liquidity support. 

Fed conference on new central paradigm

Great conference at the Board of Governors last week: Central banking, before, during and after the crisis. “Everybody” was there, but unfortunately only by invitation. The program is out on the web, including Bernanke’s intro remarks, where he noted that:

“the events of the past few years pose serious challenges to the conventional, pre-crisis views and approaches of central banks and other financial supervisors”, and “we have much to learn about the workings and vulnerabilities of our modern, globalized financial system and its interactions with the broader economy”

Interesting papers by Gertler, Shin, Goodhart, Orphanides, Duffie and Aycharia (plus all the others “who is who” of academic central banking research). Should be worth the read.

No papers yet from the concluding discussion among Mervyn King, Caruana and Shirakawa, but obviously a lot to be discussed.

As Gillian Tett of the FT observed recently : “the crisis has tossed central banking into an intellectual limbo”.

Hopefully they found some of the answers in Washington DC last week!

Private liquidity is highly endogenous

It is official: According to Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,

In normal times, private liquidity dominates official liquidity. But private liquidity is highly pro-cyclical
and highly endogenous to the conditions that prevail in the global financial system.
The inherent endogeneity of private liquidity means that it can easily evaporate in times of
financial stress.

This is something Hyman Minsky noted a long time ago, but it’s nice to see the ECB now endorsing his views.

However, Mr. Coeuré doesn’t quite follow through in this dinner speech from the recent ECB – BIS conference on Global liquidity, as he explains the crisis with “excessive sovereign borrowing”, “gaps in regulation and supervision” and “insufficient fiscal discipline”. Nothing there about excessive bank lending or rehypotecation in the shadow banking system. But at least the belated insight that private credit is endogenous is something.