Financial Turmoil, Liquidity and Central Banks

Morten Kjærgaard, Market Operations, and Lars Risbjerg, Economics

INTRODUCTION

Since the summer of 2007, the financial markets have been characterised by turmoil. This has generated tensions in the money market in several countries and brought the central banks' liquidity management into focus.

In summary, liquidity management is based on the central banks granting short-term collateralised loans to the banks, which deposit the loan proceeds at the central bank.It is then up to the banks to redistribute the liquidity via the money market to balance liquidity supply and demand on an ongoing basis.However, the turmoil has made the banks reluctant to redistribute liquidity.

Against this background a number of central banks have implemented various measures to ease the banks' liquidity situation.While requiring collateral for all loans according to normal practice, the central banks have sought to mitigate the tensions by offering larger volumes of loans, more frequent lending and more loans with longer maturities, and by accepting a wider range of eligible collateral.

In Denmark there has not been any need or wish for extraordinary krone liquidity as a result of the turmoil, and it has not been necessary to adjust the framework for Danmarks Nationalbank's liquidity management.The situation in Denmark should be viewed in the light of Danish banks' limited exposure to the US subprime mortgages that were the source of the turmoil.^[1] Furthermore, Danish banks have built up contingency liquidity in the form of substantial holdings of certificates of deposit issued by Danmarks Nationalbank.

The turmoil has also affected the central banks' interest-rate decisions.For example, the Federal Reserve reduced the official interest rate several times, but interest-rate decisions will not be addressed in this article.The focus of this article is on the liquidity management of the Federal Reserve (Fed), the Bank of England (BoE) and the European Central Bank (ECB) and their response to the turmoil.Finally, it describes the situation in Denmark.

CENTRAL-BANK LIQUIDITY

Central-bank liquidity is the banks' current-account deposits at the central bank, i.e. the amount that the banks can use for payments.In this article "the banks" is used as a generic term for the central banks' counterparties.For example, banks and mortgage-credit institutes constitute Danmarks Nationalbank's counterparties.

While the banks can lend liquidity to each other, they cannot generate more liquidity than the volume provided by the central bank.Central banks provide liquidity primarily by means of open market operations.In practice, central banks typically grant short-term loans against collateral.The collateral normally consists of securities of high credit quality, e.g. government bonds.When a loan is transacted, it is credited to the bank's account at the central bank, which in turn receives collateral for the loan.On expiry, the principal and interest are debited to the bank's account, and the collateral is returned.In the event that the bank is unable to repay the loan, the central bank keeps the collateral provided.In this way central banks protect themselves against losses on loans.Central banks conduct new open market operations on an ongoing basis so that adequate liquidity is always available in the banking system.

The banks require central-bank liquidity for their interbank payments.Besides, liquidity supply and demand are affected by autonomous factors, which include currency in circulation, government deposits at the central bank and foreign-exchange reserves.

By means of open market operations a central bank, at given times, provides liquidity to the banking system as a whole, in the expectation that the banks redistribute it.Thus, a well-functioning money market continuously ensures that the liquidity requirement of banks with a liquidity shortage is met by banks with a liquidity surplus, at market interest rates reflecting the official interest rates.

When planning open market operations a central bank uses estimates of the autonomous factors and an assessment of the banks' normal behaviour with a view to ensuring an overall balance between liquidity demand and supply.The financial turmoil has, however, made liquidity management more difficult.Banks have become more reluctant to exchange liquidity, which has resulted in larger spreads than normal between money-market interest rates and official interest rates.

Chart 1 illustrates the exchange of liquidity. In the example, bank B's liquidity requirement exceeds its borrowing from the central bank.

Bank B would normally cover this by borrowing in the money market from bank A, which is assumed to have a liquidity surplus.But in a situation of turmoil, blockages may occur in the money market, e.g. as a result of bank A building up its own contingency liquidity, preferring deposits at the central bank where the funds can be made available at short notice.

In situations of turmoil, bank A places more liquidity than normal at the central bank, while the central bank lends a larger amount to bank B against collateral,whereby the short-term interbank market is partly replaced by balances at the central bank.

Due to the tensions in the money market, a number of central banks have had to adjust their liquidity management.The normal procedures of the Fed, BoE and ECB and their response to the turmoil are outlined below.

INSTRUMENTS OF THE FEDERAL RESERVE, THE ECB AND THE BANK OF ENGLAND

The operational target of all three central banks is to ensure that the overnight money-market interest rate reflects the official interest rate.They also have the same overall framework for implementing monetary policy.

The three central banks impose an average reserve requirement on the banks.This means that the banks must maintain a certain average minimum deposit at the central bank for a reserve maintenance period of about one month in the ECB and BoE and of two weeks in the Fed.The purpose of imposing reserve requirements is to stabilise the overnight interest rate.This gives the banks an incentive to lend liquidity in the money market when the overnight interest rate is high compared to the interest rate on deposits in reserve requirement accounts.On the other hand, the banks have an incentive to maintain ample reserves in periods when the overnight interest is low.As regards the BoE, the banks may themselves determine – within certain limits – the size of their reserve requirements and change them from month to month.

The three central banks mainly offer liquidity through open market operations, holding auctions of the liquidity offered at given times.

The ECB primarily provides liquidity through weekly main refinancing operations where the banks can raise 7-day loans against collateral.The ECB determines a minimum bid rate in advance, which is its official signal rate.The ECB then fixes a marginal interest rate based on the bids, and all bids at the marginal rate or higher are allotted liquidity at the bid rate.The ECB also conducts longer-term refinancing operations every month, offering 3-month loans on market terms.In case of liquidity fluctuations affecting interest rates in the short-term money market, the ECB may conduct fine-tuning operations. This may e.g. take place at the end of the reserve maintenance period when the reserve requirement is to be fulfilled.

The BoE also conducts weekly open market operations offering a given volume of liquidity as 7-day loans against collateral at a pre-determined interest rate.In addition, the BoE's open market operations include monthly auctions offering loans with a maturity of 3, 6, 9 or 12 months against collateral and direct purchase of bonds.The BoE conducts regular fine-tuning operations at the end of the reserve maintenance periods to ensure that the banks' reserves correspond to the reserve requirement.

Unlike the ECB and the BoE, the Fed's open market operations do not follow a pre-determined schedule.Every morning the Fed decides whether to conduct open market operations.The bulk of the liquidity provided by the Fed comes from direct purchases of government bonds from the banks.However, the ongoing liquidity adjustment is conducted via short-term loans against collateral, typically overnight loans.

All three central banks have a standing lending facility that enables the banks to borrow against collateral on a day-to-day basis at their own initiative.The interest rate is higher than for open market operations – typically 1 percentage point.The lending facilities act as a safety valve to relieve out liquidity shortages in the interbank market and constitute a ceiling on the money-market interest rate.The facilities are only intended to cover a marginal borrowing requirement in relation to open market operations and are only used to a very limited extent.Furthermore, US banks have traditionally been reluctant to use the Fed's standing lending facility, i.e. the primary credit discount window, because in the US banking sector this is regarded as an indication that the bank in question is having difficulties.

In addition, the ECB and the BoE have a standing deposit facility allowing banks to place overnight deposits at a lower interest rate than for open market operations.The deposit and lending rates of the standing facilities create an interest corridor which limits the fluctuations in market interest rates.For both central banks the deposit and lending rates are 1 percentage point lower or higher, respectively, than the official interest rates.However, in the case of the BoE, the corridor narrows to +/- 0.25 per cent on the last day of the reserve maintenance period in order to facilitate the fulfilment of reserve requirements without major fluctuations in short-term interest rates.

THE CENTRAL BANKS' RESPONSE TO THE TURMOIL

The design and use of the central banks' instruments is key to accommodating the banks' mutual exchange of liquidity.The central banks can mitigate tensions in the money market in different ways by increasing the availability of liquidity.In a sluggish money market it is important that a sufficiently large number of banks have direct access to central-bank liquidity, and that the eligible collateral for the loans is sufficiently broad-based.Other important factors are the volume of loans, their maturity and the frequency of open market operations.

All other things being equal, increasing the volume of central-bank loans gives the banks easier access to liquidity.This supports activity in the money market, because it is easier to obtain liquidity later if a loan is granted to another bank.All the central banks have in periods sought to reduce tensions in the money market in this way.Frequent open market operations are normal practice for the Fed, but the ECB in particular, and the BoE, have facilitated the banks' fulfilment of their liquidity requirements during the turmoil by also increasing the frequency.

Chart 2 shows the development in the ECB's lending, the banks' deposits in current accounts and the reserve requirements. The ECB has from time to time provided considerable liquidity in excess of the reserve requirement.This is particularly true at the beginning of the reserve maintenance periods.Forthe reserve maintenance period overall, average liquidity has been close to the reserve requirement, however.This reflects the banks' lack of incentive to hold more reserves than required, as surplus reserves are non-interest-bearing.On the other hand, the deposit corresponding to the reserve requirement accrues interest at the average marginal rate in connection with the weekly open market operations during the reserve maintenance period.

The central banks have provided extra liquidity in situations when the overnight money-market interest rate indicated increasing demand in relation to supply.Both the ECB and the Fed supplied significant volumes of liquidity in early August when the turmoil started.The ECB supplied almost 100 billion euro on 9 August, and on 10 August the Fed supplied the largest volume since September 2001. The BoE did not increase the liquidity supply until the reserve maintenance period starting in September when the banks chose to raise their reserve targets.

The international money markets calmed down during parts of October and November,but in December tensions increased again due to uncertainty concerning the liquidity situation at the turn of the year.Banks in the euro area normally adjust their account balances in connection with year-end reporting with a view to balance-sheet reporting in their financial statements. This implies that the banks reduce their lending and increase their deposits of liquid funds.The central banks facilitated the situation by offering loans with maturities reaching overyear-end.

Another common feature of the central banks' response to the turmoil has been to increase the volume of long-term loans. Chart 2 shows the development for the ECB.The central banks sought to enhance certainty for the banks concerning the liquidity situation over a longer period of time.Their response should also be seen in the light of especially the long-term money-market interest rates rising as a consequence of the turmoil.Initially, the Fed offered longer term loans than normal in its discount window.Later it also set up the new Term Auction Facility, TAF, offering by auction a given volume of liquidity with a maturity of about one month.

A substantial number of banks have access to the ECB's refinancing operations, and the range of eligible collateral is very broad. This is why there have been no adjustments in these areas during the turmoil.

By comparison, access to the Fed's open market operations is much more limited in terms of both the number of counterparties and the types of eligible collateral. This reflects the fact that the banks that have access to the open market operations should be able to participate in open market operations on a daily basis and at very short notice.The Fed has chosen to accommodate liquidity availability to a wider range of banks by reducing the interest rate on loans in the discount window, which is accessible to a large number of banks subject to broadly-based collateral.For the new TAF, the group of counterparties and types of eligible collateral are the same as for the discount window.The BoE expanded the collateral base in connection with auctions concerning 3-month loans, the volume of which was also increased.

There have been several indications of dollar shortage during the period of turmoil, not only in the USA, but also internationally.The fact that only few banks participate in the Fed's open market operations, combined with a tendency for those banks to hold back liquidity due to their exposure to the financial turmoil, impeded the normal provision of dollar liquidity to foreign banks.In order to facilitate access to dollar liquidity outside the USA, the Fed established swap lines for the ECB and the Swiss National Bank of 20 and 4 billion dollars, respectively. This enabled banks in the euro area to bid for dollar liquidity through the ECB.The banks have also been able to apply the collateral applied in connection with ECB lending of euro liquidity.

The above adjustments to the central banks' liquidity management were prompted by general problems in the market and were targeted at the market as a whole.However, the BoE was also compelled to make a special liquidity facility available to Northern Rock, which is a major player in the mortgage market.The bank had a considerable deposit deficit and was highly dependent on the capital and money markets, and those financing sources dried out.Northern Rock's assets were provided as collateral, and the BoE was also guaranteed that the Treasury would cover the loss if the assets turned out not to cover the BoE's loans.On 17 February 2008 the government proposed temporary nationalisation of Northern Rock.

DENMARK

In Denmark, central-bank liquidity is made up of the banks' current-account deposits at Danmarks Nationalbank.Current accounts are demand accounts used for settlement of the banks' payments.

On the last banking day of each week Danmarks Nationalbank conducts regular open market operationsallowing banks to raise 7-day loans against collateral.The collateral base consists primarily of Danish government securities, mortgage-credit bonds and covered bonds.

The banks can deposit the loan proceeds in a current account or in certificates of deposit, which the banks can also purchase in connection with the regular open market operations.The lending rate equals the rate of interest on certificates of deposit, while the current-account rate is slightly lower.

Danmarks Nationalbank's open market operations are conducted through an open window where the banks' demand for loans and certificates of deposit is accommodated at an interest rate determined by Danmarks Nationalbank in advance.

In the period between the open market operations, liquidity may be affected by factors other than Danmarks Nationalbank's open market operations, e.g. payments into or withdrawals from the central government's account or interventions in the foreign-exchange market.

A ceiling has been imposed on the total current-account deposits of the banks at the close of the day, and overdrafts from day to day are not allowed.The purpose of this ceiling is to prevent the build-up of large current-account deposits that may be used for speculation in changes in interest and exchange rates.Danmarks Nationalbank will always supply more liquidity if the total current-account deposits become very low.This serves to prevent problems in the daily settlement of payments.Danmarks Nationalbank provides liquidity by buying back certificates of deposit.On the other hand it will issue more certificates of deposit if the current-account ceiling is reached.Certificates of deposit thus form part of the counterparties' contingency liquidity in case of problems in connection with the settlement of large payments.The banks can also trade certificates of deposit among themselves and thus exchange liquidity without any credit risk.

The Danish financial sector has only to a relatively modest extent been exposed to the subprime mortgages to US homeowners that were the source of the turmoil, and the international financial turmoil has not given rise to extraordinary open market operations or adjustments to Danmarks Nationalbank's liquidity management.

In recent years the banks have built up a relatively large liquidity buffer in the form of increased holdings of certificates of deposit.There are indications of a moderate increase in contingency liquidity during the period of turmoil.The banks thus increased their borrowing from Danmarks Nationalbank beyond what can be explained by the liquidity drain from the autonomous factors.From August to December 2007, the autonomous factors drained liquidity of kr. 78 billion, while the banks' loans from Danmarks Nationalbank grew by kr. 114 billion. No further accumulation of contingency liquidity has taken place after the turn of the year.

SUMMARY

The financial turmoil has been demanding for central banks as providers of liquidity.The central banks have implemented a number of measures to instil confidence among the banks about the availability of liquidity.The specific measures have varied from country to country depending on the countries' monetary-policy instruments.The measures include more frequent open market operations and larger loans, a larger supply of long-term loans, extended collateral base and new lending facilities.

LITERATURE

Bindseil, Ulrich, Benedict Weller and Flemming Würtz (2003), Central Bank and Commercial Banks Liquidity Management – What Is the Relationship?, Economic Notes, Vol. 32(1), pp. 37-66.

Board of Governors of the Federal Reserve System (2005), The Federal Reserve System: Purposes and functions.

Board of Governors of the Federal Reserve System (2007), Federal Reserve and other central banks announce measures designed to address elevated pressures in short-term funding markets, Press release, 12 December.

Clews, Roger (2005), Implementing monetary policy: reforms to the Bank of England's operations in the money market, Bank of England, Quarterly Bulletin, Summer.

Danmarks Nationalbank (2003), Monetary Policy in Denmark, 2nd edition.

ECB (2004), The monetary policy of the ECB.

ECB (2007), The collateral frameworks of the Federal Reserve System, the Bank of Japan and the Eurosystem, ECB Monthly Bulletin, October.

Geithner, Timothy (2007), Restoring market liquidity in a financial crisis, Welcoming remarks at the Second New York Fed-Princeton University Liquidity Conference, December 13.

Lund, Jakob Windfeld (2007), Turmoil in the Financial Markets, Danmarks Nationalbank, Monetary Review, 3rd Quarter.

Mishkin, Frederic S. (2007), Financial instability and the Federal Reserve as a liquidity provider, Speech at the Museum of American Finance Commemoration of the Panic of 1907, New York, New York, October 26.