Paul Fisher: Liquidity support from the Bank of England - the Discount
Window Facility
Speech by Mr Paul Fisher, Executive Director for Markets of the Bank of England, at the
National Asset-Liability Management global conference, London, 29 March 2012.
* * *
Introduction
The Bank of England's market operations are designed to allow the use of its balance sheet
to deliver on its two core purposes of monetary and financial stability. Specifically, they allow
us to perform three important tasks. First, to implement in the market the decisions of the
Monetary Policy Committee (MPC) on Bank Rate and, since March 2009, on the quantity of
asset purchases financed by the issuance of central bank reserves (better known as
Quantitative Easing or QE). Second, they enable us to provide liquidity insurance to the
banking system and hence reduce the cost of any unexpected disruptions to the commercial
banks' payment services to the UK economy. Third, they provide the bedrock for the Bank's
market intelligence work, which feeds in to both core purposes.
Over the past three years or so, I have used opportunities such as this to set out the policy
objectives and rationale underpinning the Bank's various market operations.1 Today, I want
to fill in some pieces of the jigsaw puzzle by discussing in detail two of the new operations
which provide liquidity insurance: the Discount Window Facility (DWF) and the
recentlyannounced Extended Collateral Term Repo Facility (ECTR). In order to do that, I first want to
summarise the principles governing the Bank's provision of liquidity insurance, and how
those have contributed to a complete overhaul of the Bank's operations since the start of the
financial crisis in 2007.
Principles for providing liquidity insurance
In order to understand our liquidity insurance facilities, it is helpful first to think about why
they are necessary at all - and that relates to what it is that commercial banks do.2 In their
simplest form, banks provide customers with a variety of basic financial services: an
on-demand source of bank notes; deposit and savings accounts; payment services; and they
supply credit, to both businesses and households.
These are critical services for the efficient functioning of the UK economy - done well they
make us all better off. But providing them generates a necessary degree of risk. The most
obvious is credit risk - if you lend someone money, you might not get it back. That risk does
not justify support from the central bank - the consequences of bad commercial lending
decisions should be borne by banks' management and the shareholders, and not by the UK
taxpayer.
Banks also bear liquidity risk, which might crystallise for reasons beyond their control. For
example, bank liabilities typically comprise a large amount of on-demand customer deposits,
and their assets tend to comprise longer-term loans to households and firms. This maturity
mismatch between assets and liabilities is an essential part of the banking business model
and large unexpected shocks can leave even well-run banks short of liquidity. And the
degree of spill-over to the system as a whole is particularly elevated in the banking system.
By way of contrast, if a car manufacturer fails, people will buy other cars. If a bank fails, it can
cause a loss of confidence and hence a run on other banks.
Commercial banks can self-insure against liquidity risk by holding buffers of liquid assets
which they can readily exchange for cash in the money markets. It is obvious in hindsight
that the banks' collective holdings of liquid assets prior to 2007 were insufficient to cope with
the ensuing crisis and that they should hold more - although precisely how much more is still
being debated in international regulatory circles. Nonetheless, liquid asset buffers can only
go so far - one can always conceive some event which renders a bank's self insurance
buffer insufficient. Such scenarios could range from short-term IT malfunctions which prevent
payments being received, through to full-blown global financial crises. That is why the central
bank needs to stand ready as lender of last resort.
As the monopoly supplier of central bank money, which is the most liquid asset of all, the
central bank is able to provide liquidity, either bilaterally (in the event of an idiosyncratic
shock), or to the banking system as a whole (in the event of a market-wide shock). In doing
so, there are some important constraints.
Support from the central bank is not available to prop up a failing institution. The Bank of
England will only lend to those commercial banks that are, in its judgment, solvent and
viable. This is for two related public policy objectives. First, the central bank needs to guard
against moral hazard - that is, our policies should not undermine the commercial banks'
responsibilities to manage their own liquidity prudently. If commercial banks know that we will
always bail them out, then they may take too much risk: the bank's shareholders and
management might seek to profit from the extra gains arising from risky lending whilst relying
on the authorities when the risks crystallise. Second, and in consequence, the central bank
needs to protect its own balance sheet (and hence public money) against the risk of loss. As
a result, central bank lending should be collateralised, and subject to haircuts which are
prudently calibrated to be sufficient if the counterparty was to default.
In a crisis, it can be difficult to judge whether a bank really does have just a temporary
liquidity problem or an underlying solvency problem. There is no shying away from the fact
that difficult judgements have to be made about when and whether the central bank should
offer actual liquidity support.
Before the recent crisis, there was only limited publication of the terms and conditions of
possible liquidity support. An approach of "constructive ambiguity" was adopted by many
central banks, to guard against moral hazard. But in the events that occurred, that approach
limited the extent to which central banks - and market participants - could act quickly within
an appropriate risk management framework.
Drawing on the lessons of the crisis, the Bank's approach to providing liquidity insurance has
evolved radically since 2007. During that period, the Bank has reviewed the use of its
balance sheet, and implemented a series of public and transparent reforms to its facilities.
Many of the proposals were set out in a consultation document published in October 20083
and the resulting work programme has led to an almost complete overhaul of the Bank's
Sterling Monetary Framework (SMF).4
The new Framework includes arrangements for implementing monetary policy as well as
permanent facilities for providing liquidity support to the banking system. The latter
arrangements include the Bank's overnight Operational Standing Facilities (OSFs, which
offer overnight liquidity against high quality collateral in the event of frictional payment
shocks), its regular Indexed Long Term Repo auctions (ILTRs, which offer a pre-determined,
fixed quantity of central bank reserves, for a period of 3 or 6 months, against a wide range of
eligible collateral),5 the Discount Window Facility (DWF) and most recently the Extended
Collateral Term Repo (ECTR) facility. The rest of my talk today is focused on the policies
underpinning these latter two facilities.
Designing the Discount Window Facility
The Bank's DWF, which was introduced in October 2008, is an on-demand facility, designed
to provide bilateral short-term liquidity support in the face of either idiosyncratic or
systemwide shocks. Eligible counterparties, who have applied for and been granted access to the
DWF, can apply to borrow at any time, obviating the need to wait until the Bank's next
scheduled market-wide operation.
The design of the Bank's DWF was shaped, in part, by lessons learnt from the Special
Liquidity Scheme (SLS). The SLS was a temporary scheme, introduced in April 2008 to
alleviate the extreme pressure on the UK banking system. It was designed to provide a
significant, one-off, long-term liquidity upgrade against legacy assets that had become
illiquid. Under the scheme, the Bank lent £185bn of Treasury bills, for up to three years, in
exchange for high quality but illiquid assets created before the end of 2007 - mostly
securitised mortgages and covered bonds.6
Like the SLS, DWF drawings are typically structured as a liquidity upgrade - exchanging
borrowers' illiquid collateral for UK Government securities (gilts in the case of the DWF). The
Bank is willing to accept a very wide range of collateral in the Discount Window - a much
wider set than that which is normally eligible in the Bank's regular open market operations.
The Bank's published documentation sets out four categories of eligible collateral (Level A to
Level D). The contents of each are determined by the market liquidity of each eligible asset
class. The least liquid collateral set includes own-name securities or pools of loans: that is
where a borrowing bank itself has originated, or has some other close financial links to, the
assets comprising the collateral.
Other features of the DWF are very different from those underpinning the SLS. First, DWF
borrowings typically have a term of 30-days.7 The DWF is intended to act as a bridge in the
event of a liquidity shock. For a relatively mild shock that might support a counterparty to the
next regular ILTR,8 or to planned debt issuance. For greater shocks, the solution might
require more fundamental changes in the firm's balance sheet (e.g. asset disposals).
In any case, before it will agree to lend in the Discount Window, the Bank of England will
need to be convinced that there is a credible path to a point where access is no longer
required. Crucially, the DWF is only intended to provide short-term liquidity support to
banks - and is not intended to be used as a replacement for funding, which can only be
sourced in a sustained way from private markets. And it is vital to stress that the DWF is not
a 100% committed facility. At the point of application, the Bank will make a fresh,
independent assessment of whether it deems the counterparty to be solvent and viable.
To guard against moral hazard, the DWF charges fees which make it unattractive in normal
times, but which would be more attractive under stressed market conditions. Because the
DWF is structured as a liquidity upgrade, the fees charged are linked to the type and liquidity
of collateral delivered. The more illiquid the collateral, the greater the value of the upgrade,
and hence the higher the fee. In addition, as part of the Bank's desire to ensure that
commercial banks are adequately incentivised to seek their own liquidity insurance, the cost
of borrowing increases with the size of the draw. The resulting matrix of fees is summarised
in Table 1.
Table 1
Fee table for DWF drawings of gilts
Fees (bps) Collateral Type
Level A Level B Level C Level D
% of sterling
(e.g. high quality (e.g. liquid and (e.g. illiquid (e.g. own-name
eligible liabilities
sovereign debt) high quality transferable securitisations
mortgage and securitised loans and covered
corporate bonds) and mortgages) bonds, and loans)
0-10%
50 75 125 200
10-20%
20-30%
75 125 200 300
>30%
100 175 275 400
At the Bank's discretion
There is one further important point to make regarding the policy decisions underpinning the
design of the DWF. It relates to the challenges associated with providing liquidity support
while not compromising the Bank of England's ability to conduct monetary policy. To
implement interest rate decisions, the Bank must, through its market operations, adjust the
supply of central bank money in response to changes in the demand for banknotes and
reserves, given the MPC's policy rate (Bank Rate). During periods of stress there may be
large shifts in the demand for reserves and so the Bank's market operations need to be
designed to meet both our monetary policy and financial stability objectives without conflict.
In normal times, Bank Rate is set within a reserves averaging framework, in which
commercial banks choose their own targets for reserves balances held at the Bank but are
then required to meet those targets on average over the monthly maintenance period and
are remunerated at Bank Rate. The Bank of England supplies just enough cash to the
system so that banks can collectively meet their targets, and a combination of the
Operational Standing Facilities and the inter-bank market should guide short-term market
interest rates towards Bank Rate. This framework relies on the Bank ensuring the amount of
sterling cash in the system is in line with that demanded, given Bank Rate.
The liquidity swap structure of the DWF does not involve an extra injection of cash and so
helps to avoid any direct impact on the setting of Bank Rate. The Bank may, however, decide
in exceptional circumstances, to lend cash instead. That might be required if, for example,
the gilt repo market was not functioning properly, or the size of the required draw is
sufficiently large that the Bank deemed it unlikely that the counterparty will be able to repo
the gilts without causing undue volatility in the markets. In such circumstances either the
Bank would need to relax the tolerances around banks' reserves targets to accommodate the
extra cash in the system, or drain the excess cash, which it can do by one of several means.
In either case, the Bank would not compromise its capacity to set Bank Rate or purchase
assets.
Since the start of the Bank's asset purchase programme in March 2009, this interaction has
not been binding. Because quantitative easing directly injected more cash into the economy,
forcing the commercial banks to hold more reserves than they would otherwise have chosen
to, the reserves averaging system was suspended and all central bank reserves have since
been remunerated at Bank Rate. But when reserves averaging is re-introduced in due
course, we will need to be conscious of the potential interaction between liquidity support and
monetary policy operations. The framework is designed so that both policy objectives can be
achieved at the same time.9
Recent policy initiatives/issues
a) Pre-positioning
Since the DWF was put on a permanent and transparent footing in late 2008, the Bank has
been working on a number of initiatives to develop the facility further. One important
expansion has been the Bank of England's capacity to assess and lend against portfolios of
loans (e.g. mortgages) as well as securities.10 There are a number of benefits to having this
capacity. Portfolios of loans can be easier for the Bank to assess from a risk perspective, as
they do not embed the complex structures sometimes present in securitised assets. And
securitising loans into asset backed securities - such as RMBS - is both complex and
expensive for the firms, and generally only available to those large enough to have an
existing securitisation programme. The ability to accept raw loan collateral means that
smaller counterparties, without securitisation platforms, are not disadvantaged when
positioning collateral at the DWF. Since financial instability can start with smaller banks just
as easily as larger ones, expanding the universe of possible Discount Window counterparties
could lead to significant financial stability benefits.
Alongside the expansion of eligible collateral to loan portfolios, we have been encouraging
banks to "pre-position" their collateral. Pre-positioning involves the commercial banks
ex
identifying, and the Bank of England assessing, various types of collateral ante, so that it
need not be assessed at short notice in the event of a sudden and unexpected need to
borrow at the Discount Window. Assessing varied pools of illiquid collateral can be extremely
complex and time consuming. The Bank may not be able to lend much, if at all, against
collateral where it has not had time to conduct sufficient due diligence. As a result, it is vital
that such collateral is pre-positioned well ahead of any need to draw. One of the benefits
from having a more public and transparent facility is that such due diligence is much easier to
carry out.
The pre-positioning drive has gathered pace in the last year or so - there is now over £265bn
of collateral pre-positioned for use in the DWF. After applying appropriate haircuts to each
piece of collateral pre-positioned, this means the Bank could, subject to solvency and viability
assessments and repayment plans, lend around £160bn in the DWF without the
complications of further detailed collateral checks.11 Although not a substitute for firms
building up their own holdings of high quality liquid assets to a more satisfactory level, that
represents a very substantial "war chest" of potential liquidity in the event of significant
adverse shocks. There is limited cost to the counterparty of pre-positioning, as collateral can
be withdrawn on demand for use in other operations or market transactions. The extent of
pre-positioning varies across firms, however, and we hope to continue to both sign up new
counterparties and encourage firms to increase further the quantity of pre-positioned
collateral over time.
b) Addressing perceptions of stigma
Quarterly Bulletin
The latest data, published in the Bank's this week, show that there was no
borrowing under the DWF between its introduction in late 2008 and 30th September 2011. In
part, that is likely to reflect the fact that the UK banking system (in aggregate) has not been
short of sterling liquidity over this period - the Bank has injected large amounts of liquidity
through a variety of operations including both the SLS and expanded LTR operations. And
since early 2009 asset purchases under the MPC's QE programme have mechanically led to
a large increase in the stock of central bank reserves. Of course more reserves in total do
not ensure an appropriate distribution of liquidity across individual banks - but it does help.
Some people have suggested that lack of use of the DWF may reflect concerns about stigma
attached to such support facilities. Stigma might arise from counterparty concerns that their
use of the DWF would be detected, coupled with a perception by others that only weak
institutions would ever use a bilateral, on-demand facility. In fact, as we have made clear, the
DWF is not there to support a failing firm - when borrowing from the DWF, firms must have
convinced the Bank of their ability to repay.
Addressing the stigma issue is extremely complex and has potentially affected a number of
central bank operations internationally. One way of addressing perceptions of stigma is
through appropriate policies on disclosure. While headline results of the Bank's auctions,
such as total bids and total amount allotted, are published immediately at their conclusion,
we publish only the average daily amount outstanding in the DWF over the quarter,
aggregated across firms, and even that with a one-quarter lag. The intention is that DWF
drawings will not be disclosed until after they have terminated. Moreover, where structured
as a liquidity upgrade, DWF borrowings would not be visible on the Bank's balance sheet,
reducing the risk that any drawing is unintentionally revealed.
Another possibility is that counterparties are concerned about being "spotted" using
DWFsourced gilts in the repo markets. For the majority of cases, however, I think there are simple
ways to alleviate these concerns - for example by encouraging banks to set up multiple repo
counterparty relationships and rotate their regular gilt repo business amongst them. That
would deliver wider business and financial stability benefits, even in the absence of the DWF.
Indeed, the FSA requires banks to test their repo capacity by lending out gilts from their liquid
asset buffers.
Ultimately we expect a counterparty would draw on the DWF if it had to, despite any stigma
concerns. The risk is that the perception of stigma might delay an application to borrow,
making a firm's liquidity position more perilous. The solution to this problem requires the
Bank to work closely with both the supervisors and the commercial banks themselves, to
ensure appropriate timing of any use.
c) Extended collateral term repo facility (ECTR)
The most recent policy development in our liquidity insurance tools has been the addition of
the ECTR facility in December 2011. Although it is a contingent facility, the ECTR is a
permanent part of the Bank's Sterling Monetary Framework.
The design of the ECTR shares elements of both the ILTRs and the DWF. Like the ILTRs, it
is a competitive auction, designed to provide reserves to the banking system as a whole.
Participants submit quantities they would like to borrow and a price (expressed as a spread
to Bank Rate, subject to a minimum of 125bps) that they would be willing to pay. The
disclosure policy (total amount bid for/allocated) is also very similar to the ILTR, which
together with the market-wide nature of the operation, should help alleviate any perceived
stigma associated with the facility.
The ECTR's collateral arrangements, however, are similar to the DWF - borrowings can be
backed by the full range of eligible collateral, so long as it has been pre-positioned in the
Discount Window beforehand.
The purpose of the ECTR is to make liquidity available against the least liquid collateral, to
the market as a whole, and would be offered only if there was likely to be multiple take up. (If
only a single firm needed support they could be directed to the DWF.) Consistent with all the
Bank's facilities, only firms judged to be solvent and viable would be eligible to participate.
Subject to that, all counterparties that have access to DWF would be eligible to participate in
any ECTR operations.
Although the facility has been announced, the Bank has not yet offered any operations under
the ECTR. That reflects our judgment that market conditions have not yet been consistent
with a likely demand for its use. The Bank would revisit this decision in the event of any
marked deterioration in market conditions.
Conclusion
In this speech today, I have set out some of the principles behind the Bank of England's
revised, permanent and public facilities for providing liquidity insurance to the banking
system. We expect banks to self-insure for most of their liquidity needs - and while there has
been encouraging progress to date, more is needed on that front. But if necessary, the Bank
of England stands ready to provide support to solvent and viable institutions, against
sufficiently good collateral, for an appropriate fee. It is important that commercial banks
preposition their collateral so that due diligence can be performed and the maximum benefit
achieved. The new Sterling Monetary Framework, which has been reformed almost in its
entirety since 2007, reflects our experience during the crisis and lessons from some of the
temporary measures that had to be put in place. Doubtless the Framework will continue to
evolve in future, but the provision of such published facilities should help to make the system
more resilient in the years to come.