Eligibility easing and the lender of last resort

Transcription

1 Eligibility easing and the lender of last resort Thomas F. Huertas Few issues are as important or as controversial as the lender of last resort. Indeed, this function is arguably what makes central banking central to the financial system and to the economy at large. As is well known, the lender of last resort (LOLR) function played a key role at various stages of the crisis. Whether central banks did (AIG) or did not (Lehmans) act as LOLR mattered greatly, as did how they implemented and communicated LOLR, when they did provide it (Northern Rock). In contrast, eligibility requirements have received less attention. Yet, these determine whether a facility is an ordinary one or a lender of last resort (LOLR)/emergency liquidity assistance (ELA). LOLR/ELA starts where ordinary central bank facilities stop, i.e. where eligibility for such facilities ends. Hence, LOLR/ELA can take the following forms: LOLR1: To eligible borrowers on the basis of ineligible collateral; LOLR2: To ineligible borrowers on the basis of eligible collateral; and LOLR3: To ineligible borrowers on the basis of ineligible collateral. During the crisis central banks initiated a policy that might be labelled eligibility easing or EE. This reduced the need for central banks to act as LOLR/provide ELA by: Expanding the collateral eligible to support normal central bank liquidity facilities; and Extending the range of counterparties eligible to access normal central bank liquidity facilities. Partner, EY Financial Services Risk and Chair, EY Global Regulatory Network. This paper reflects remarks made at the Harvard Law School Symposium on Building the Financial System of the 21 st Century on 31 March 2017 in Frankfurt. The opinions expressed here are personal.

2 In addition, central banks extended the term of normal liquidity facilities. Separately, in the context of quantitative easing (QE), central banks expanded the range of assets acquired directly via open market operations. In the US the Fed bought massive amounts of mortgage-backed securities. In the Eurozone the ECB has stated to purchase both government and corporate bonds as part of its supplemental asset purchase program. These central bank purchases have supported the price of such assets, enhanced their market liquidity and improved the creditworthiness of institutions holding such assets. In effect, central banks have acted as buyers of last resort. Taken together, EE and QE proved remarkably effective in stabilising the world economy. Indeed, in my view it is one of the principal reasons that economists describe 2008 to 2010 as the Great Recession and not the start of the Greater Depression. Huertas, EE and LOLR Page 2

3 Now that the recovery is finally taking hold, central banks are struggling with the question of when and how to end QE. A similar debate needs to take place with respect to EE. With respect to the range of assets eligible to serve as collateral for ordinary central bank facilities, central banks have three options: 1. Retain the current broad range; 2. Return to a narrower range; 3. Regard revisions to the range as a macro-prudential tool. In such an approach, the central bank would narrow the range of assets eligible as collateral as an upturn progressed and broaden the range as a downturn took hold. In effect, this would create a countercyclical accordion. Note that the central bank could supplement these measures by varying the haircut on assets that do remain eligible as well as varying the term of its ordinary facilities. With respect to the counterparties eligible to access ordinary central bank facilities, authorities have to decide the basis on which this will occur. Should access be: 1. Restricted to banks only; 2. Restricted to banks and broker dealers; 3. Open to all financial institutions; or 4. Open to all (i.e. available to both financial and non-financial institutions). Note that any solution that goes beyond banks alone, undermines the notion that banks are special and therefore weakens the rationale for bank regulation. Huertas, EE and LOLR Page 3

4 Finally, there is the question of the terms and conditions on which LOLR/ELA is granted. Although there is a consensus that the terms for LOLR/ELA should be harsher than those for ordinary facilities, greater clarity is needed on the terms and conditions for ordinary facilities. Which regime is more constructive: ambiguity or certainty? I believe central banks should draw a distinction between LOLR/ELA and ordinary liquidity facilities. In the former ambiguity is essential: no one should have the right to receive LOLR/ELA (the review of EE will determine which counterparties have the right to request LOLR/ELA). In contrast, certainty is constructive with respect to ordinary central bank facilities: eligible counterparties should be able to expect that the central bank will provide liquidity upon the pledge of eligible collateral. Huertas, EE and LOLR Page 4

5 This distinction is particularly important in connection with resolution. If a bank asks for LOLR/ELA, this may be a sign that it has reached the point of non-viability. Correspondingly, the central bank must rapidly decide whether to: - Decline granting the request for LOLR/ELA. This will almost certainly lead to the immediate failure of the bank and force the supervisor/resolution authority to put the bank into resolution, regardless of the views that of these authorities may have regarding the bank s condition. - Grant the request for LOLR/ELA. This permits the bank to continue to function, but it also creates the possibility that the authorities exercise forbearance. Indeed, without liquidity support from the central bank, the supervisor alone cannot (except where the bank finances itself exclusively with insured deposits) exercise forbearance. In making this decision, the central bank should take the following into consideration: - Is the bank requesting LOLR/ELA solvent? If it is not, LOLR/ELA could amount to what under normal bankruptcy procedures might be judged a fraudulent conveyance. Note that the decision itself (whether or not to grant LOLR/ELA) may have an influence on asset prices and hence on the solvency calculation. - If solvent, has the bank requesting LOLR/ELA reached the point of non-viability (or does the request stem from failures in technology or in the market for particular instruments)? - Must the bank requesting LOLR/ELA immediately meet obligations to payments, clearing and settlements systems and/or to CCPs (collectively financial market infrastructures)? If the bank does not meet its obligations, will the infrastructure remain robust? - If the central bank refuses to grant LOLR/ELA, is the resolution authority ready to resolve the bank? In cases where the bank requesting LOLR/ELA has reached the point of non-viability and the resolution authority is ready to resolve the bank, the central bank and resolution authority should make clear that they will pursue the following presumptive path: - Put the bank into resolution; - Bail-in instruments qualifying as TLAC so that bank is not only solvent but meets minimum requirements for CET1 capital; - Have the bank-in-resolution meet its obligations to financial market infrastructures so that it can retain access to such infrastructures; and - Make ordinary central banking facilities available to the recapitalised bank on the basis of the bank s unencumbered assets. In particular, the central bank should stand ready to take over both the financing and the collateral from repo providers and other secured lenders. It makes no sense for the central bank to create the impression that it will refuse to grant the recapitalised bank access to ordinary central bank facilities. Such a position would undermine practically any resolution plan that the resolution authority might devise. In sum, EE deserves as much attention as QE. It too played a significant role in containing the crisis. The time has now come to determine its future role, both as a macro-prudential tool and as a determinant of what really constitutes the last resort when it comes to LOLR/ELA. Huertas, EE and LOLR Page 5