Thomas Jordan: Central banks in action - financial market turbulences
and policy measures
Speech by Mr Thomas Jordan, Member of the Governing Board of the Swiss National Bank,
at the 36th General Assembly of the Association of Foreign Banks in Switzerland, Geneva,
6 June 2008.
The author thanks Caesar Lack for very helpful comments and suggestions.
* * *
1. Introduction
It is a pleasure and honour for me to have the opportunity to speak at the Annual Meeting of
the Association of Foreign Banks. The foreign banks are the fastest growing group of banks
in Switzerland. This demonstrates the attractiveness of Switzerland as a financial centre. At
the same time it also shows how important the foreign banks are for Switzerland. I am
therefore very much looking forward to interesting interaction with my distinguished
audience.
In my talk, I will focus on the financial market crisis and the policy measures taken by central
banks in response to the crisis. I will also try to identify some preliminary lessons that central
banks have learned through applying these measures.
In recent weeks, financial markets have improved, to some extent, from the situation that
prevailed at the height of the turmoil in mid-March: risk premia have fallen on most assets,
and equity prices have recovered. Even money markets, although still tense, have improved
somewhat. These developments have given rise to the hope that the worst of the financial
crisis might have passed by now. However, it may be too early to give the all-clear. There
could still be a number of setbacks; we have already witnessed periods of apparent
improvements in recent months, only to see the crisis return in full force. Thus it is still
difficult, at this point of time, to draw conclusive lessons for the future.
2. Objectives and instruments of monetary policy
Before I delve into the subject of the financial market crisis, let me begin by reminding you of
the objectives and instruments of monetary policy. These will be important things to keep in
mind later on.
stability, stability
The objectives of monetary policy can be neatly summarised as and
stability. To be more precise - the objectives of monetary policy are price stability, economic
stability, and financial stability. We can order these three stability objectives according to the
time lag between the specific monetary policy action and the effects of that action on the
particular objective. The longest lag between action and reaction is to be found in the
transmission of monetary policy to prices. Thus, monetary policy should aim at price stability
in the long run. Under long run, I understand a horizon of up to a number of years. In the
medium term, with a horizon of one to two years, monetary policy can be used for smoothing
economic cycles. And in the short run, immediate action may sometimes be required to
safeguard the stability of the financial system.
We can also order the three stability objectives according to the degree to which monetary
policy is responsible for the eventual outcome. Regarding price stability, monetary policy is
fully responsible for prices in the long run. Or to put it more simply - a broad-based and
sustained rise in prices is always attributable to monetary policy. As for economic
fluctuations, monetary policy can affect them, but it cannot control them entirely.1 Concerning
the stability of the financial system, the role of monetary policy measures is mostly limited to
crisis management, through reacting to increased liquidity demand and providing support to
the banking system in times of crisis. In the longer term, central bank action does not
determine financial stability directly, it is other factors, such as regulation, supervision, and
incentive structures which determine the stability of the financial system.2
I would also like to say a few words on the hierarchy of these objectives. It is sometimes
argued that only one objective can be pursued - on the assumption that a central bank has
only one instrument, usually a short-term interest rate. Some objectives must therefore be
subordinate to other objectives. In theory, this view is certainly correct.
However, practice is more complex than theory. In practice, the problem of having more
objectives than instruments in monetary policy is less severe than theory might suggest.
There are three reasons for this.
First, the three objectives are not necessarily contradictory. On the contrary, they are
mutually conditional: A policy that ensures price stability in the long run also contributes to
stabilising the economy and the financial system.
Second, even if the objectives sometimes appear to require a contradictory stance for
monetary policy, it is possible - even with one instrument only - to successfully pursue
several objectives. This is due to the fact that the impact of monetary policy on the different
objectives occurs with different lags. To give an example: Monetary policy action aimed at
ensuring financial stability in the very short run or aimed at stabilising the business cycle over
the medium term does not necessarily endanger price stability in the long run if the stimulus
is removed in time and compensated for by a more restrictive monetary policy stance
afterwards. In other words, there are several paths for the monetary policy instrument that
are consistent with the long-term objective of price stability.3
Third, and most importantly, monetary policy is not restricted to one instrument alone. Price
stability and economic stability do indeed rely on the same instrument. However, the financial
market crisis has clearly shown that central banks have a battery of other instruments at
hand, with which they can manage liquidity during times of financial market turmoil.
This leads me to the second part of my introduction, namely, the central bank's main
monetary policy instrument and the transmission mechanism. For most central banks in
developed countries with floating exchange rates, the main monetary policy instrument is a
short-term interest rate, referred to generally as the "policy rate". While in many other
countries the policy rate is an overnight rate, the SNB has an operating target for the
3month Swiss franc LIBOR (London Interbank Offered Rate).
Without going into detail, I would like to stress two important points with respect to the
transmission from the monetary policy instrument to the economy. First, monetary policy
works primarily through financial markets. By setting the policy rate, monetary policy affects
exchange rates, interest rates, risk premia and asset prices in general, and is thus
transmitted via financial markets to the real economy and to prices.4 Monetary policy
therefore strongly relies on well-functioning and liquid markets. The tensions in the money
markets in recent months therefore posed a serious headache to most central banks. Not
only did money market tensions indicate potential problems for financial stability, but it also
threatened the smooth functioning of the transmission mechanism of monetary policy.
The second important point concerning the transmission of monetary policy is the fact that it
is not the current value of the policy rate that matters. Rather, it is the expected future path of
that rate that determines the stance of monetary policy. For example, a central bank can
have an impact on the economy simply by signalling that its own view about the future path
of the monetary policy rate is different from the current market view. If the central bank is
credible, market expectations will adjust correspondingly and financial prices will henceforth
reflect the new view communicated by the central bank.5
3. Chronology of the crisis
After these preliminaries, I will now turn briefly to the origins and the course of the financial
market crisis, and in particular, the liquidity tensions brought about by the turmoil.
The US housing market stands at the epicentre of the financial market crisis. After rising for
several years, US house prices peaked in 2006. In the ten years between mid-1996 and
mid2006, house prices in the US almost tripled, growing on average at an annual rate of 11%.6
An important development during the house price boom was the deterioration of lending
standards, which can be traced back to the "originate-to-distribute" financial intermediation
model. Originate-to-distribute (as opposed to originate-to-hold) is a process whereby new
loans are not held by the bank, but bundled, sliced, repackaged, and sold to investors. While
the incentives in the originate-to-hold process favour the origination of good loans which can
be expected to be serviced and paid back, the incentives in the originate-to-distribute
process favour the origination of as many loans as possible, in order to profit from the fees
involved in the underwriting and securitisation process. It is thus not surprising that credit
standards decreased during the boom.
After house prices had peaked in 2006, it became more and more obvious to some market
participants that many sub-prime borrowers would soon be unable to service their debt.
Prices of sub-prime-backed securities started easing in 2007. As 2007 progressed, the
deteriorating sub-prime market began affecting the confidence in related structured finance
products and, in August 2007, led to a general repricing of risk and the deterioration of
liquidity in many market segments, not least in the money market. As banks became more
concerned about their own liquidity and more cautious about counterparty risk, they became
less willing to lend, especially on the unsecured money market, at maturities longer than a
few days.
As a central banker, I would date the outbreak of the financial market crisis to the beginning
of August, when overnight interbank rates increased sharply. The first central banks to react
were the ECB and the SNB on 9 August, when both banks conducted extraordinary
finetuning operations. Soon afterwards, other central banks followed suit, also injecting
additional liquidity.
So far, there have been three waves of money market strains. After subsiding somewhat in
late September, the strains increased again in November, exacerbated by year-end
pressures. The third wave started in March. The worst peak of the financial market crisis so
far was attained in mid-March, when Bear Stearns was taken over by JPMorgan. The
takeover, which was facilitated by the Federal Reserve, resulted in a calming of markets.
Since mid-March, financial markets have improved somewhat, with the exception of money
markets, which are still rather tense.
4. Action by central banks
I would now like to discuss in more detail the ways in which central banks reacted to the
financial market crisis. Given that operational frameworks differ from one central bank to
another, and given the highly technical nature of the subject, I will restrict myself to some
stylised facts relating to the actions taken by central banks in general and those taken by the
Swiss National Bank in particular.
Central banks responded to the financial market turmoil gradually, by progressively shaping
and expanding their instruments. At the outset, central banks tried to counter rising
shortterm money market rates by applying their existing instruments in a more flexible way, by
adjusting the size, frequency, and the conditions of their discretionary open market
operations. For example, in order to react to the fluctuations in the demand for reserves, the
SNB now conducts more frequent fine-tuning operations than in the past.
Although the enhanced use of fine-tuning operations managed to stabilize overnight rates,
term spreads remained high. Central banks felt that it was necessary to address this
situation, because it not only reflected an increase in credit risk but was also a sign of a lack
of liquidity in these markets.
Central banks therefore introduced new facilities with longer maturities and offered
exceptional long-term financing operations. For example, in September, the SNB carried out
a CHF 5 billion repo auction with a three-month maturity. Until then, the maturity of its daily
repo auctions had usually been one week. In an internationally coordinated effort,
longerterm operations of this kind were intensified in December, in order to meet heightened
demand surrounding year-end pressure. In December, the SNB conducted several repo
transactions with maturities between three and four weeks to cover year-end requirements.
In March, there were three auctions of three-month Swiss franc repos.
A consequence of tensions in the money markets was an inefficient distribution of liquidity.
While some institutions tended to hoard liquidity, other institutions found it hard to come by.
Some central banks therefore enlarged the range of counterparties for their liquidity
management operations. A good example of this is the Term Auction Facility (TAF)
introduced by the Federal Reserve in December, which provides 28-day term loans. This
facility functions essentially like an open market auction, but is open to depository
institutions, while access to the Fed's regular open market operations is restricted to 20
primary dealers. Furthermore, some central banks broadened the range of eligible collateral
for their operations. This allowed the banks to keep their best collateral for the money
market.
Another problem during the crisis was the dollar liquidity shortage of European banks. This
resulted in additional uncertainty and in a high intraday volatility of dollar rates. In an
internationally coordinated effort, the Federal Reserve therefore, in December, established a
US dollar swap line for the ECB and the SNB. On December 17, the SNB, for the first time
ever, conducted a repo auction in foreign currency and provided four billion US dollars of
liquidity for 28 days to its counterparties. Due to the persistent strains in the money market,
the swap lines were increased in March and again in May. Currently the SNB is providing a
total of 12 billion US dollars of liquidity to its counterparties through bi-weekly auctions of six
billion dollars each. These repo transactions will continue to be renewed until conditions
improve. For Switzerland, the motivation for participating in this coordinated action is twofold.
First, our counterparties obtain easier access to dollar liquidity. Second, money markets in
different currencies are highly interrelated. Fewer tensions in the dollar market also mean
fewer tensions in the Swiss franc market.
The Federal Reserve's swap line is only the most visible result of the intense cooperation
between central banks that has taken place since the outbreak of the crisis. In general,
international consultation among central banks has proved very useful in managing the
financial market crisis.
A further important action taken by central banks was the introduction of facilities that allow
banks to swap collateral that is less liquid for securities that are highly liquid, such as
government bills. In March, the Federal Reserve introduced a Term Securities Lending
Facility (TSLF), which allows to lend up to USD 200 billion of Treasury securities to primary
dealers in exchange for a broad range of collateral, including asset-backed securities. In
April, the Bank of England introduced its "Special Liquidity Scheme", a new facility which
allows banks to temporarily swap their mortgage-backed and other securities for UK
Treasury Bills. The aim of these collateral swap facilities is twofold: first, balance sheets of
financial institutions become more liquid, and second, the prices of the collateral are
indirectly supported, as fire-sales of such assets accepted as collateral become less likely.
An attractive feature of collateral swaps is that they leave the amount of central bank money
unaffected. They support liquidity in the banking system without driving short-term money
market rates below the policy target. Furthermore, the size of these operations can,
potentially, be very large, since there are almost no limits as long as the Treasury provides
the securities or the central bank can issue its own bonds.
The single most far-reaching action by a central bank in the crisis so far, however, was the
Federal Reserve's decision to facilitate the takeover of Bear Stearns by JPMorgan, in that it
took over risky assets in significant quantities. By stepping in, the Federal Reserve put an
end to a disorderly de-leveraging process on the part of highly interconnected financial
institutions, and probably made a crucial contribution to defusing the third and most recent
wave of the financial market crisis.
Given its open access policy with respect to counterparties and the broad collateral base, it
was not necessary for the SNB either to increase its range of counterparties or to expand its
list of collateral.7 Neither has it been necessary to introduce a facility for swapping illiquid for
liquid assets, so far.
How should we assess the impact and success of central bank actions so far? Although they
have helped to limit tensions in the money market, the situation is still far from normal.
Despite all the liquidity measures that have been taken, term premiums in the money market
remain elevated. This provides further evidence of the fact that the lack of confidence in the
market cannot easily be removed by central bank action alone. Market participants have to
undertake the necessary steps themselves to restore market confidence.
5. Lessons and consequences for liquidity management operations
What lessons can we learn from the financial market crisis? There are, of course, many
lessons to be learned. However, I would like to concentrate on those that are related to
central bank liquidity management operations.8
Liquidity management vs. changes in the stance of monetary policy
The first lesson concerns the distinction between liquidity management and monetary policy.
The crisis has made clear to financial markets, but also to central banks, that in order to
safeguard financial stability during financial market turbulence, central banks do not depend
solely on the monetary policy rate, but have a broad arsenal of liquidity management
instruments at their disposal. To illustrate this point: Lowering the policy rate is not the only
thing a central bank can do to ensure financial stability in the short run; a central bank has
other efficient instruments at hand, which, depending on the situation, may be equally or
even better suited to safeguarding financial stability. Also, these instruments do not affect the
stance of monetary policy and thus the economic stability and price stability objective, or only
do so to a lesser degree.
The difference between liquidity management operations and changes in the stance of
monetary policy has been poorly understood by many observers. Liquidity injections, as large
as they may have appeared, have in general not resulted in significantly higher levels of
reserve money, because they were only of a temporary nature. The liquidity management
operations have thus not resulted, as is sometimes claimed by analysts, in huge amounts of
excess liquidity, nor can they necessarily be equated with a more expansionary monetary
policy stance. Many of the recent central bank liquidity management operations have not
affected the monetary policy stance.
However, there have of course been changes in the monetary policy stance during the
financial market crisis: the Federal Reserve has significantly lowered interest rates, and in
some other countries, the path of the (partly realised, partly expected) monetary policy rate is
lower now than last August, which is equivalent to an expansion in the monetary policy
stance. However, changes in the stance of monetary policy must not be viewed as an
immediate reaction of monetary policy to the financial market crisis, but rather as a reaction
to the expected effects of that crisis on economic growth and on inflation. This view also
explains the apparent hesitation of some central banks to lower rates, in spite of the serious
financial market turmoil. The precise way in which the financial market crisis will affect
economic growth and inflation has not been obvious - and is still not obvious.
Operational target and the stance of monetary policy
The second lesson concerns the setting of the stance of monetary policy in times of financial
turbulence. The financial market crisis led to a tightening of credit conditions and to higher
risk premia, which is tantamount to a more restrictive monetary policy stance. In order to
offset tighter credit conditions and higher risk premia, an adjustment of the policy rate may be
appropriate. Such an adjustment is not necessarily synonymous with a more expansionary
monetary policy and does not necessarily increase inflation risks. The concept of the Swiss
National Bank implicitly takes into account changes in certain risk premia: by steering and
stabilising the 3-month Libor, which includes a risk premium, the SNB is constantly adjusting
the repo rate in order to offset changes in the risk premium.
Appropriate liquidity facilities
The third lesson concerns appropriate liquidity facilities. In order to react quickly and flexibly,
central banks must be capable of injecting and withdrawing large amounts of liquidity at short
notice. In order to distribute liquidity to banks when the money market is impaired, central
banks must also be able to conduct operations with a maximum set of counterparties and
against a broad range of collateral. In order to address liquidity premia, central banks should
be able to intervene in maturity ranges which are longer than the maturities at which they
usually operate. Central banks may also need to enlarge the basket of eligible collateral
during a crisis. Furthermore, the crisis has made it clear that the effectiveness of a standing
loan facility in times of crisis may be reduced if there is stigma attached to its use.
Moreover, central banks should also have alternative plans up their sleeves on how to deal
with severe and persistent illiquidity in the money market. The collateral swap facilities are
not traditional liquidity management operations aimed purely at injecting liquidity. They
provide a temporary relief of banks' balance sheets and therefore indirectly support liquidity
in the money market. However, central banks should use such drastic measures only in
exceptional cases. Central banks also need exit strategies for such eventualities.
Finally, the crisis has also shown that, in order to successfully address financial market
turmoil, central banks need enough room to manoeuvre and a liberal legal framework. A tight
legislative corset hampers flexible and innovative reactions to the different contingencies a
financial crisis might throw up.
The financial market crisis has demonstrated that the SNB's liquidity management framework
is up to its task. The SNB repo auctions allow for quick and flexible action, at different
maturities, and facilitate both the provision of and withdrawal of liquidity. The secured repo
market in Swiss francs, which was introduced in 1998, has proved very useful in recent
months, as it has granted access to liquidity in the secured money market to banks with good
collateral. The SNB conducts its auctions with a large group of counterparties and regularly
encourages eligible banks to participate in the repo auctions. The SNB even permits banks
domiciled abroad to participate in its repo auctions. Shortly before the financial market crisis,
the SNB expanded its repo baskets by including more currencies. Nevertheless, the lessons
from the financial market crisis will be taken as an opportunity to review the tool box of
instruments and, if necessary, improve it.
The crisis has also demonstrated the limits of central bank intervention. Only in the short
term can central bank intervention safeguard financial stability . Ultimately, it is market
participants themselves who must overcome the crisis, by enhancing transparency,
reestablishing markets for illiquid assets, rebuilding confidence among banks, writing off bad
debt, recapitalising balance sheets and running down excessive leverage. Central bank
action is a first-aid kit to ensure that the patient does not die on the site of the crash from a
loss of blood, but the subsequent healing process is up to the patient.
Taking moral hazard into account
The final lesson concerns the moral hazard problem arising from liquidity management
operations. Roughly speaking, moral hazard is the name we give to the situation in which,
financial institutions and investors incur higher risks than they would otherwise because they
expect the central bank to intervene in times of crisis. This, in turn, may increase the
likelihood of future crises.
Moral hazard is relevant both at the level of systemically relevant market players and at the
level of markets as a whole. Market participants that are "too big to fail" or "too
interconnected to fail" may automatically factor in the help from central banks when deciding
about their business strategy. However, smaller players and investors that cannot count on
individual help may also take the expected central bank reaction to financial market crises
into account in their investment decisions.
Because of moral hazard, central bank intervention in order to safeguard financial stability in
the short term may be destabilising in the long term. Therefore, when reacting to a financial
crisis, the benefits of central bank intervention in terms of short-term stabilisation must be
weighed against the long-term cost in terms of moral hazard. This is no easy task, because
the future cost is unknown and far away, while an ongoing financial market crisis is a clear
and present danger.
Recent events have clearly shown that moral hazard is not just a textbook phenomenon, but
is in fact a serious problem. Market players do indeed rely on the implicit insurance granted
by central banks and other authorities, and central banks and authorities, having no choice,
do indeed step in to support markets in a crisis.
There is no easy way to address the moral hazard problem. However, the right time to tackle
it is probably not primarily during a financial crisis, but during the preceding calm. Since a
strict declaration of no intervention by a central bank may not be fully credible, regulation
must aim to neutralise the distortion of incentives which financial market participants face
because of moral hazard. Larger capital and liquidity requirements are probably a robust
means of countering that distortion. Larger capital and liquidity requirements do not eliminate
moral hazard, but they limit the risk of an accident and thus the cost to the public in the event
of a rescue.
Related to the moral hazard issue is also the issue of the risk-bearing capacity of a central
bank. A central bank can only act as a lender of last resort if it has the means to act as one.
This is especially important if the banking system has relatively large liabilities in foreign
currency. While a central bank can, in principle, create an unlimited amount of domestic
currency, its foreign currency reserves are limited. Recent events have highlighted the
importance of an adequate level of foreign reserves for financial stability.
6. Conclusions
I would like to close today by stating that, in my opinion, extraordinary central bank action
was indeed justified to counter financial market turmoil, and that it was also successful in
halting the developments in mid-March, which threatened to develop into a vicious circle of
fire sales and falling asset prices.
However, central bank action cannot resolve the underlying problems. It can only provide
temporary relief. The solution to the crisis must come from market participants themselves.
Central bank action appears to have been relatively successful. But there's one thing that
every economist knows only too well, and it is that there is no such thing as a free lunch. So
the question naturally arises, what has been the cost of the recent extraordinary central bank
interventions?
The first potential cost of recent central bank action is in terms of moral hazard. One of the
biggest challenges that lie ahead of central banks and regulators, once the crisis has settled
down, is to consider how to reduce moral hazard in financial markets, in order to prevent this
factor from becoming the reason for the next - and potentially even bigger - financial crisis.
The second potential cost of recent central bank action could be in terms of inflation. The
financial market crisis affects inflation in various ways. On the one hand, the crisis has
resulted in a more expansionary monetary policy stance in some countries. This has
probably contributed to the rise in commodity prices in recent months, and to the rise in
energy prices, in particular. On the other hand, the expected economic slowdown associated
with the crisis should dampen inflationary pressure. However, the aggregate effect of the
crisis on inflation is far from obvious. The crisis has thus increased the uncertainty
surrounding the inflation outlook. Consequently, central bankers are currently challenged not
only on the financial stability front; they also need to be extremely alert to developments on
the price stability front.