Paul Fisher: Central bank policy on collateral
Paper by Mr Paul Fisher, Executive Director, Markets, and Member of the Monetary Policy
Committee of the Bank of England, summarising recent discussions with a range of market
contacts, London, 14 April 2011.
This paper sets outs the Bank of England's approach to collateral policy, which is driven by a combination of
monetary and financial policy objectives and the need to protect the Bank's balance sheet.
* * *
I would like to thank Simon Ainsworth, Ronnie Driver, Charles Gundy, Sarah John and Alan Sheppard for their
help in preparing this paper.
The Bank of England, like most central banks, has two core purposes. The first is to maintain
price stability, defined by a 2% CPI inflation target, mandated by the government on an
annual basis. The second is financial stability, which entails detecting and reducing threats to
the financial system as a whole. The Bank meets these objectives through the use of its
balance sheet. It supplies banknotes and central bank reserves (the most liquid and risk-free
forms of payment in the economy) to the banking system, in a process which helps to anchor
short-term market interest rates around the Bank Rate set by the Monetary Policy Committee
(MPC).1 And to support financial stability, the Bank provides liquidity insurance to the banking
system as a whole. It does so by offering to supply additional reserves (or UK government
debt in some operations) against a wider range of collateral and at longer maturities than
would be necessary just to set Bank Rate.2
During the financial crisis, the provision of liquidity insurance to the banking system caused
an expansion in the Bank's balance sheet from around £80bn in 2006 to around £250bn in
early 2010. Charts 1 and 2 below show the evolution of the Bank's balance sheet through the
crisis. In addition the Bank provided liquidity through a collateral upgrade in its Special
Liquidity Scheme (SLS) introduced in April 2008. That involved swapping £185bn of treasury
bills in exchange for high quality but temporarily illiquid private sector collateral (as is
conventional for a collateral swap, this was done off-balance sheet).
A significant expansion of the balance sheet was certainly the right thing to do in the face of
the biggest ever global financial crisis - as Walter Bagehot wrote as early as 1873, "to avert
panic, central banks should lend early and freely to solvent firms, against good collateral and
at high rates." But such a huge expansion in the balance sheet was by no means simple to
execute, nor risk-free.
Like any other business, especially one in the public sector, the central bank needs to protect
its own balance sheet. The consequence of a significant loss could be to damage credibility,
threaten independence and impair the central bank's ability to discharge its statutory
responsibilities. A central bank will also be keen to avoid the moral hazard involved in
encouraging a commercial firm to undertake particular types of risk-taking activity. There are
certain principles that a central bank should therefore observe:
(1) It should not lend to any bank whose prospective solvency is seriously in question.
(2) It should always take sufficient, good-quality collateral against its lending.
(3) Central bank operations should be designed to deliver public policy objectives, not
to support the profitability of any particular commercial firm.
(a)
Bank of England consolidated balance sheet
Chart 1: Liabilities Chart 2: Assets
£ billions
£ billions
300
300
Long-term repos
250
Notes in Circulation
250
Short-term repos
Reserve balances
200
Other liabilities
200
Loan to APF
150
150
Other assets
100
100
50
50
0 0
2006 2007 2008 2009 2010 2011 2006 2007 2008 2009 2010 2011
(a) Data to 16 March 2011
That may sound like a simple set of rules, but there are deep policy issues to consider when
it comes to implementation. In particular, there are policy decisions required in the following
dimensions:
(i) eligibility (what collateral should be accepted, and what should not);
(ii) valuations and haircuts (how much is the collateral worth?);
(iii) what fees should apply, if any, and
(iv) limits (how much diversification should we seek across the collateral delivered?).
These are important questions for the banking system as a whole, and have presented new
and complex risk management challenges for central banks over the past few years. It is on
these issues that we focus in this paper.3 To start with, we briefly outline some of the main
features of the Bank's lending operations.
The sterling monetary framework
The Bank's main activity in the sterling market prior to the financial crisis was via its
shortterm repo open market operations (STR OMOs). Those regular weekly operations provided
the banking system with the right level of reserves such that short-term market interest rates
would remain close to Bank Rate set by the MPC.4 In addition, in order to reduce the size of
weekly STR OMOs to a manageable size, the Bank undertook longer-term repo OMOs
(LTR OMOs) of 3, 6, 9 and 12 months maturity. The remaining operation of note was the
Standing Facilities in which a commercial bank could borrow from, or lend to the Bank
overnight, albeit at a less attractive rate than Bank Rate.
The financial crisis, and the associated expansion of the balance sheet to provide liquidity
insurance to the banking system, was a true "game changer" for the Bank of England: the
Sterling Monetary Framework has been almost completely redesigned over the past few
years. The increased demand for liquidity insurance necessitated a large and rapid
expansion in the scale of lending and the range of collateral the Bank took in its operations.
In the Autumn of 2007, the Bank extended the range of collateral acceptable in its LTRs
(henceforth eLTRs) and increased their size somewhat. In April 2008, in the wake of Bear
Stearns' failure, the Bank introduced the SLS. Through that scheme, the Bank eventually lent
£185bn of 9-month T-bills against a wide range of private-sector collateral - mostly UK
RMBS backed by legacy mortgages - for up to 3 years. Following the failure of Lehman
Brothers in September 2008, the Bank further extended the collateral allowed in eLTRs and
initiated a massive expansion in its lending at the 3 month maturity, eventually peaking at
£180bn in early 2009.
In October 2008, the Bank also introduced a permanent Discount Window Facility (DWF),
which can provide liquidity to counterparties on a bilateral basis against a wide range of
collateral, ranging from US treasuries and German bunds to self-originated ABS. The
Standing Facilities which had played this role were re-launched as the Operational Standing
Facilities (OSFs), more clearly intended to cope with operational disruptions and short-term
market volatility. More recently, in June 2010, the Bank replaced the temporary eLTRs with
permanent Indexed Long-Term Repo (ILTRs) operations that regularly offer the system
3 and 6 month liquidity, against a wide pool of eligible collateral.
In designing its permanent liquidity insurance operations, the Bank was very mindful of the
need to balance the benefits to systemic stability, the incentives for banks to manage liquidity
risk prudently, and the need to minimise the risk taken onto the Bank's balance sheet. In
particular, the aim of the Bank has been to leave the credit and market risks associated with
collateral with the counterparty, so that we only provide the intended liquidity insurance and
not any official underwriting of the underlying risks.
Underpinning these objectives are some additional underlying principles:
(a) the Bank does not accept any collateral that it feels it cannot value and then
riskmanage effectively;
(b) the Bank's prices for lending in its liquidity insurance operations can vary with the
liquidity of the collateral delivered and the amount lent, so that use of these facilities
only becomes attractive in stressed conditions.
These principles ensure that the Bank can manage its own risks prudently and that
counterparties are encouraged to manage their risks similarly.
Eligibility
The Bank's risk preferences are very different from those in commercial financial institutions.
Like a commercial bank, collateral bestows post-default recovery value. But unlike
commercial banks, we do not use collateral for liquidity management purposes. The Bank
does not re-pledge collateral to raise liquidity for example. The emphasis is on the protection
that the collateral offers in a default situation. Although the eligibility of collateral depends on
a number of factors, in all cases the collateral must be of sufficiently high credit quality so
that it presents a low risk to the Bank in the event of a default by a counterparty.
The Bank's operations vary in their policy objectives, and so have different eligible collateral
pools which are tailored to match the policy goals. In operations designed solely to
implement monetary policy, only a narrow range of collateral is allowed. By design, these
operations will normally involve lending at close to Bank Rate. The Bank's counterparties
have a financial incentive to optimise their use of collateral in these operations by selecting
the cheapest to deliver. If any relatively illiquid or lower credit securities are allowed in the
narrow collateral set, then the commercial banks will have an incentive to exploit that
premium. That would mean that the central bank's monetary policy operation could become
a regular source of funding (and profit) for the firm. This can matter if, for example, it creates
distortions in demand for those lower quality assets. In the Bank of England's monetary
policy operations - the STR OMOs and the OSFs - eligible collateral includes only securities
issued by those sovereign issuers of the highest credit quality and which are expected to
remain liquid in all but the most extreme circumstances.
In providing liquidity insurance operations, the policy objective is to provide liquidity under
stressed conditions and this can be most effectively done against a wider collateral set,
although similar adverse selection concerns can apply. Where collateral is of differing market
value, that ideally needs to be reflected in the price of lending so that there are no market
distortions. The Bank has a number of different collateral pools to reflect this. The (first)
"wider" pool is available for use in the Bank's Indexed Long-Term Repo (ILTR) operations
and includes both the narrow collateral set and certain private sector securities which would
be expected to remain liquid in most conditions (including the debt of a number of other
sovereigns and certain third-party originated ABS). The ILTRs allow firms to bid to get
reserves against either the narrow or this wider collateral set at different prices. The Bank
decides how much is allocated against wider collateral, depending on how much the
commercial banks bid for it (ie reflecting market demand).5 It also meets other policy
objectives such as providing a signal about the degree of stress in the market.
A yet wider range of collateral is eligible in the Bank's Discount Window Facility (DWF). DWF
collateral is divided into four sets, depending on its underlying liquidity. Levels A and B are
the same as the "narrow" and "wider" sets allowed in OMOs. Levels C and D go wider still
(Table 1). The price for drawing depends on the collateral a firm has to offer: the less liquid
the collateral, the higher the fee. Essentially, the haircuts play the role of protecting the
Bank's balance sheet while the fee plays the role of discouraging use except under stressed
conditions and therefore avoiding market distortions in normal times. It also compensates the
Bank for taking the liquidity risk.
Table 1
Collateral eligible in post-crisis Bank operations
The Bank has been encouraging counterparties to "pre-position" collateral in the DWF, which
allows us to conduct ex-ante due diligence and advise on the eligibility and likely advance
rate of the collateral (ie the amount we would lend against it) were it to be called upon in a
live draw. Pre-positioning provides counterparties with the insurance they need were an
unexpected risk to suddenly crystallise. In that scenario, having a pool of collateral that has
already been assessed and is ready for use might significantly reduce the delay between an
DWF draw-down application and the release of funds.6 That could be vital in a crisis.
Under exceptional circumstances, the Bank can use its lender of last resort function to
engage in Emergency Liquidity Assistance (ELA) outside of the publicly available operations.
In principle, that could be against any collateral that the Bank could value and risk manage.
The Bank comes to an independent judgment about which collateral should be eligible in all
its operations, based on its own assessment of the credit, liquidity, transfer risk (the risk that
collateral/liquidity is not returned by the counterparty because of political intervention) and
any legal risk of the counterparty and issuer. By making its own judgment, the Bank ensures
that it is not reliant on credit ratings agencies for such assessments.7 Rather, it forms its
opinion drawing on a range of indicators and stress tests.
To judge liquidity, the Bank will typically draw on data about the depth of the market in a
range of market conditions, bid-offer dealer spreads and outstanding issuance in making its
assessment. On legal and transfer risk, the Bank regularly reviews the jurisdictions in which
its counterparties originate. By taking account of a range of indicators, in a non-mechanical
way, the Bank is able to assess the suitability of particular issuers' debt securities for a
collateral set.
Changes to the narrow collateral set
The Bank's collateral policy is still evolving. On 11 February the Bank announced that, with
effect from 1 July 2011, it will accept in its narrow collateral basket sovereign debt securities
denominated in Sterling, Euro, US and Canadian Dollars and issued by the UK, the US,
Germany, France, the Netherlands and Canada. That is a wider range of currencies than
many of its international counterparts. For example, the ECB, Federal Reserve and Bank of
Japan only accept securities denominated in domestic currency. The Bank of England takes
a broader range of currencies, to make sure that the narrow collateral set is large and deep
enough for our monetary policy operations not to cause frictions in the sovereign collateral
markets. The risk is offset by additional haircuts for foreign currency.
The choices of which currencies and issuers were to be allowed in the narrow collateral set
were decided principally on grounds of liquidity, not credit. A number of AAA issuers are
assigned to the wider collateral set principally because their debt stock in issue is too small
and/or too tightly held such that bid-offer spreads are relatively wide and/or more volatile in
the secondary market. Chart 3 shows a simple analysis of some of these factors.
Those changes were not a response to short-term conditions in some sovereign debt
markets. Rather, they form an important part of the transition to the Bank's long-term
collateral policy, which was initiated following the October 2008 consultative paper on the
Bank's market operations. The changes have expanded the universe of collateral eligible in
the Bank's operations. And all the narrow collateral previously eligible will remain permissible
under the new regime as either narrow or wider collateral.
Chart 3
Metrics of sovereign credit risk, market liquidity and size(a)
US
300 5 yr CDS premia
France
Germany
250
Netherlands
Canada
UK
200
Italy
Spain
150
Belgium
Austria
Australia
100
Sweden
Denmark
50
Finland
Norway
0
-1 0 1 2 3 4 5 6 7
-50
10yr bond bid-offer spread (bps)
(a) The size of the bubbles is representative of the total amount of
sovereign debt outstanding (in sterling terms). Ireland and Portugal
are not shown, as their respective bubbles lie significantly to the
north-east of the other countries identified in the Chart. Bubbles for
Cyprus, Japan, Luxemburg, New Zealand, Slovenia and Switzerland
are also not shown for clarity (although they are accepted as wider
collateral). Data as at 11 April.
Valuation
The Bank's valuation of collateral plays a key role in protecting the Bank against loss in the
event of a counterparty default. Where available, the Bank uses market prices to value a
security. Where no market price is available or those that are available are judged to be
unreliable - for example because they are out of date - the Bank calculates a model price to
value a security, based on a standard bond pricing model of discounted expected future cash
flows. The Bank uses its judgment to assess the validity of that model price, including by
comparing it to similar traded securities where available, and drawing on any relevant market
intelligence it has gathered from market participants.
Haircuts
The Bank's haircuts are designed to reduce the likelihood that the Bank would incur a loss if
forced to realise and liquidate collateral in the wake of a counterparty default. So the haircuts
not only have to protect against the risk of counterparty default (credit risk), but also take
account of the likely value of that collateral in stressed liquidity conditions (market risk).
As a result, the Bank adopts a graded approach, with "base" haircuts varying by the type of
collateral offered reflecting the different associated risk characteristics. It includes the likely
correlation of risk e.g. that the value of a counterparty's collateral will fall as the counterparty
itself becomes stressed. Over and above those base haircuts, and where appropriate, the
Bank imposes idiosyncratic haircut add-ons, based on both the type of collateral and the
counterparty. In some cases, that reflects stress tests applied to the underlying assets.
Changes in market prices can, of course, affect the value of the collateral the Bank has taken
in its operations. As a result, the Bank calls margin on any shortfall.8 In its sterling operations,
the Bank calls margin daily and is moving to that standard for all other transactions.
Limits
The Bank also manages the risk on its balance sheet using concentration limits. Those serve
institutions
two purposes. First, they help the Bank diversify across - for example,
counterparties can only bid for a maximum of 30% of the funds on offer in the Bank's ILTRs.
That helps ensure that any single counterparty doesn't corner the market for reserves
instruments
(intentionally or by accident). Second, they help diversify across in the wider
collateral pool - for example, the Bank requires that the adjusted market value (AMV) of
securities that any single issuer delivers to the Bank as wider collateral in OMOs is less than
the greater of £250 million or 25% of its total OMO collateral delivered.
Other recent policy initiatives
The Bank has, for a number of years, been refining and improving its collateral policy. In
November 2010, the Bank announced that it would allow counterparties to use "raw"
(i.e. unsecuritised) loans as collateral in the DWF. By removing the need to securitise assets,
that initiative expands the range of collateral that banks would be able to use in times of
stress. And, by removing derivatives and certain structural features embedded in RMBS, it
will improve the Bank's ability to manage the risk associated with this collateral. Moreover,
this initiative will also allow smaller counterparties, who do not have access to securitisation
platforms, or for whom the cost of securitisation is prohibitively high, to access liquidity
insurance in times of need.9 The Bank started processing applications for the pre-positioning
of loans in the DWF in January 2011.
At the same time as announcing that it would accept portfolios of loans as collateral, the
Bank formalised the next steps in its ABS transparency initiative. Following on from its
consultation in March 2010, the Bank announced that it would be phasing out the eligibility of
residential MBS and covered bonds that did not conform to certain transparency criteria.
During a year-long implementation period, running to November 2011, those securities that
do not confirm to the new standards will remain eligible for use in the Bank's operations. But
over that period, counterparties should be working to ensure that they meet the new
transparency requirements. Subsequently, in the year from November 2011 to November
2012, there will be a 12 month transition, during which the Bank will begin to apply
increasingly large haircuts to those securities that do not conform to its requirements. By the
end of November 2012, assets that do not comply will become ineligible.
The transparency initiative will help the Bank risk-manage collateral more accurately and
effectively. That means that less conservative haircuts would sometimes be required to
support a given level of borrowing. That will benefit counterparties as well as deliver risk
management benefits to the Bank.
The Bank will also require the data to be made available to investors and other market
professionals, so that they will be able to undertake their own risk analysis. That should
deliver longer-term benefit to the financial system as a whole - standardising, simplifying and
publicising the data should all reduce the mechanical reliance on third party judgments and
models, and hence reduce "single points of failure" within the ABS market (although it will be
up to market participants to make best use of these changes).
Other policy issues on the agenda
There are some big issues facing the Bank and its collateral management going forward. The
immediate challenge is to wind down the SLS to its conclusion in January 2012. The banks
have made good, early progress in reducing their use of the Scheme, unwinding the
collateral swaps ahead of their contractual maturities. As the remainder of the T-bills lent are
returned, the collateral pledged to the Bank will be returned to these counterparties for
refinancing in the market. Much of the collateral posted under SLS was RMBS and
residential mortgage-backed covered bonds, where conditions in the secondary and repo
markets have improved since the financial market seizure beginning in 2007. It is expected
that the banks will be able to generate liquidity using their mortgage assets in the private
market or by raising funding through other markets. It is noteworthy that the private sector
has recently engaged in SLS-like transactions; pension funds have been agreeing to swap
highly liquid gilts for less liquid RMBS. The pension fund, as a buy and hold investor, is
content to hold a less liquid asset on repo for a higher yield. The bank in the meantime
receives a highly liquid asset that can be used to raise cash in the repo market, or held as
part of their liquid asset buffer. It will be interesting to see how that private sector collateral
upgrade market grows and develops and, in particular, the increased transparency helps
pension funds better manage the risks in the collateral.
Conclusion
When people think about Bank of England policy questions, many rush to focus on interest
rates and, given our new responsibilities, financial policy decisions. Fewer think about the
policy issues associated with implementing those decisions. In this paper, we have tried to
set out some of the thinking behind the Bank's approach to collateral. It is driven by a
combination of monetary and financial stability policy objectives and the need to protect the
Bank's own balance sheet. To do that, we look through current market conditions to assess
the value of collateral and firm behaviour under stressed conditions. We also try to
understand the incentives that we create for our counterparties in good times and bad, so as
to avoid moral hazard and market distortions. The changes that have been made should
mean that in future, the Bank of England is more effective both in providing liquidity
insurance to the banking system and in mitigating its own risks.