Thomas Jordan: International money market disruptions, central bank
reactions and lessons learnt
Introductory remarks by Mr Thomas Jordan, Member of the Governing Board of the Swiss
National Bank, at the end-of-year media news conference, Zurich, 13 December 2007.
* * *
As early as the first half of 2007, turbulence could be observed now and then on international
financial markets. However, each event was isolated and short-lived. In the second half of
2007, there was a fundamental change in the situation. The sub-prime mortgage crisis in the
US had a substantial impact on international financial markets, the extent of which had never
been anticipated. I will cover three areas in my following remarks. First, I will discuss the
upheaval on the international money markets. Then I will talk about the reaction of central
banks, in particular that of the Swiss National Bank. Finally, I will outline some of the lessons
learnt from this crisis to date.
Serious disruptions on international money markets
At the beginning of August, the US sub-prime mortgage crisis spread like a shock wave into
the money markets of the most important currencies. In doing so, it hit the vital nerve of the
international financial system. Well functioning money markets are essential in ensuring that
financial market participants can adjust their liquidity positions. Ultimately, they are crucial for
banks' solvency and long-term commercial viability. With attention focused on money
markets, the spotlight also fell upon central banks who implement their monetary policy in
money markets by influencing the level of interest, via the supply of liquidity. Moreover, the
central banks are the only market participants who are in a position to create the liquidity
used in the interbank payment systems.
The kind of upheaval observed in the international money markets over the past few months
has never been witnessed in living history. Rumours and reports of substantial sub-prime
positions at banks led to a sudden loss of confidence in international financial institutions.
Moreover, these banks are, to some extent, uncertain about their own future liquidity
situation. Consequently, banks subsequently began hoarding liquidity and became extremely
cautious when granting credit to each another. The market for unsecured interbank loans
over longer terms collapsed and at times the market for foreign exchange swaps dried up.
Since then, banks have been unable to obtain unsecured funds for terms of more than a few
days or weeks - or have been able to do so only by paying substantial interest premiums.
There were three factors that exacerbated the money market disruptions. First, bank
securities holdings that had supposedly been first class and liquid proved to be illiquid,
thereby failing to serve as a source of supplementary liquidity. Second, other participants in
the financial markets also faltered in their supply of liquidity to the banks. Their confidence in
banks suffered because money market investments that had been considered safe suddenly
turned out to be risky. This led to the third exacerbating factor: Instead of helping the
situation, off-balance sheet investment vehicles established by the banks made it far worse.
Suddenly, these investment companies could no longer refinance themselves in the market
and the banks were therefore forced to inject their own liquidity.
Initially, the liquidity bottleneck manifested itself in the US dollar money market, above all. On
the one hand, this was due to the fact that sub-prime losses and refinancing needs mainly
affected US dollar positions. On the other, it was because liquidity hoarding also occurred
chiefly in US dollars. US dollar liquidity was particularly tight for European banks. Thus
tensions spread rapidly from the dollar money market to the euro money market, but also to
the Swiss franc money market. The extent of the upheaval on these three money markets
can be seen in graph 1 which shows the path of risk premiums, using three-month funds as
an example. Before the crisis, these risk premiums were almost negligible. They now amount
to between 50 and 100 basis points, depending on the currency. The graph also shows that,
so far, the crisis has moved forward in two waves. After normalising to some extent in
October, the situation became increasingly tense from mid-November onwards, after more
bank losses had been reported.
Stabilisation by central banks
The turbulence on the money market is challenging central banks. Although the way in which
they steer their individual money markets differs, ultimately they provide just the amount of
liquidity that is necessary to maintain the key monetary policy rate at the targeted level.
The SNB reacted rapidly, and was the very first central bank to provide additional liquidity,
which it did on 9 August, by means of fine-tuning measures. In the course of the following
days, we continued to provide the banking system with generous supplies of funds as part of
our regular auction procedure. In this way, we succeeded in rapidly defusing tensions on the
call money market. Since then, we have carrying out fine-tuning measures on a consistent
basis, in order to dampen sharp fluctuations in the call money rate in either direction. This
has allowed us to stabilise the very short-term Swiss franc money market.
However, we were unable to prevent risk premiums in interbank business from rising, since
this is largely independent of our measures. As can be seen in graph 2, the three-month
Swiss franc Libor had risen to 2.90% by mid-September 2007, which was substantially above
the level targeted by us. By international standards, however, the increase in Libor was
minimal. Our monetary policy decision of 13 September was aimed at further calming the
Swiss franc money market, by bringing the three-month Libor back down to around 2.75%.
With this in mind, we made funds available to banks for a term of three months. We did this
from the day of the monetary policy assessment onwards. It was the first time we had done
so since the introduction of the repo as a monetary policy instrument. At the same time, we
undertook a significant reduction in the repo rate used for our transactions. Our aim was to
compensate the higher risk premiums through a lower repo rate, and to move the
threemonth Libor back into the middle of the target range. The desired reaction ensued within a
few days and the three-month Libor stabilised at 2.75%. We thereby neutralised the
monetary policy impact of the higher risk premium. As announced a short while ago, we will
also be supplying the market with ample liquidity as we approach the end of the year, and
will be conducting longer term repo transactions with this in mind.
At the operational level, steering the three-month Libor proved to be a challenge, due to the
high and fluctuating level of the risk premium. Simultaneously, the benefits of our operational
flexibility became very clear. Since we are generally present in the market on a daily basis
with short-term repo transactions, we were in a position to adjust liquidity measures to
individual market conditions. Over the past few months, we have made consistent use of this
flexibility; first, by providing the banking system with generous amounts of seven-day money,
gradually lowering the repo rates as we did so, and second, by absorbing liquidity that was
no longer required as soon as the call money rate declined. In this way, it was possible to
retain overall liquidity in the bank system at an appropriate level. As you will see in graph 3,
the average level of bank sight deposits changed very little throughout the year, if we
compare each minimum reserve period with the next.
Our other operational processes have also stood up well in the turmoil of the past few
months. Payment transactions carried out between banks in the SIC system ran smoothly at
all times, although banks have made greater use of SNB intraday loan facilities. In order to
bridge liquidity bottlenecks at the end of the day, the National Bank provides a
liquidityshortage financing facility to banks. This allows them to obtain liquidity on a temporary basis
when needed, provided they have a limit with the SNB and provided this limit is continually
covered with eligible securities. The continual coverage of the limits ensures that the banks
have access to a liquidity cushion, even in critical situations. Actual use of the limits is
generally restrained, and this has also been the case in recent months.
Lessons learnt
I would like to draw your attention to some of the lessons that we have already learnt from
the current crisis. I will mention four points. First, the worldwide money market upheaval
clearly shows how highly integrated international financial markets are today. Local crises
can spread around the globe in a flash. The money market crisis is unlikely to have been
overcome yet. Confidence among financial market participants remains insufficient. The
pressure on participants who are still only able to refinance themselves in the market on a
very short-term basis remains high. As long as uncertainty with respect to the scope of the
credit problems exists, the disruptions on the money market are likely to persist.
Second, the central banks have played a fundamental role in calming and stabilising the
money markets through close consultation and targeted operations. The SNB reacted rapidly
to the tensions in the Swiss franc money market. The flexibility of our monetary policy
instruments demonstrated its value in this difficult setting. Above all, short-term interest rates
calmed as a result of the measures taken. The difficulties in bank refinancing over longer
terms and the rise in risk premiums in the money market came about through the loss of
confidence. Central banks can not compensate this lack of confidence simply by injecting
additional liquidity. On the contrary, the financial market participants themselves must take
the fundamental steps needed to restore this confidence.
Third, the crisis in the money market once again clearly demonstrates that liquidity
management is a core task of each and every bank, falling within the direct accountability of
bank executive management. Liquidity provisioning must begin in good times. It is critical that
sufficient liquid assets be held. Only first-class securities are suitable for this purpose. These
can be sold in the markets or mobilised via repo transactions, even in difficult conditions. In
an acute crisis situation, the availability of sufficient liquidity, together with a strong equity
position, is absolutely crucial.
Fourth and finally, I would like to mention that, in the Swiss franc money market, repo
business via the Swiss Value Chain has proved to be a crisis-resistant source of liquidity,
thanks to the consistent minimisation of risks. The repo market allows participants to
undertake rapid refinancing in the interbank market, independent of credit limits, thereby
making a major contribution to the stability of the financial system. That is why it is important
for the SNB that all Swiss and foreign banks operating in the Swiss franc money market join
the Swiss repo system.
4 BIS Review 150/2007
BIS Review 150/2007 5