Central bank liquidity management: A changing landscape
Andras Simor (Governor)
EUR50 Conference, Budapest
Central bank reactions to the new financial architecture
Over the past year, central banks have been preoccupied with liquidity management as never
before. Fast financial innovation led by deregulation, globalisation, liberalisation and yield hunting
in a low interest rate environment caused a significant change in banks’ strategy. Financial
intermediators moved from the “originate and hold” to the “originate and distribute” model and
created new, important and in normal time liquid segments of the global capital markets. Recent
market turbulences have shed light on the deficiencies of the “originate and distribute” model
and the operation of structured finance markets. In parallel, central banks re-examined their roles
and responsibilities as well as re-shaped their liquidity provisioning framework. I would group the
major developments into four main categories.
Central banks’ first reaction to the market turbulence was a temporary increase in the amount of
liquidity provided to their counterparties. As a second set of measures, the three leading central
banks also extended the maturity of their credit operations. The third set of measures, which can
be considered as the most extraordinary one, was the significant expansion of the range of
eligible collateral accepted in collateralised credit operations and broadening the list of
counterparties including securities broker-dealers as well as the introduction of special facilities
allowing participants to swap temporarily their high quality mortgage-backed and other securities
for highly liquid government bonds. As a fourth set of operations, the international currency
swap lines could be mentioned, which enabled central banks and their counterparties to have
access to foreign currency liquidity.
Within the lender of last resort function, central banks usually use discount window facilities, or –
in extraordinary situations – the Emergency Liquidity Assistance to respond to funding liquidity
problems of individual banks. But this time, central banks have provided funding liquidity mainly
through the adjustment of their open market operations to all market participants. Could these
actions be regarded as a new type of lender of last resort measures? I think yes, this can be
considered as system-wide liquidity crisis management.
Central banks as market makers of last resort
In managing the current financial turmoil, central banks largely ignored some of the main
principles of the Bagehot doctrine, namely lending freely, at a penalty rate to solvent but illiquid
banks, and on good banking securities. The banks and even securities broker-dealers could have
had access to central bank liquidity in exchange for illiquid collateral at normal interest rates.
Since previously highly liquid markets dried up or ceased to function, central banks started to act
as market makers of last resort, to provide liquidity against banks’ assets that became suddenly
illiquid. However, the acceptance of illiquid collateral raises several concerns.
First, let me speak about valuation issues. Central banks play a key role in pricing credit risk of
illiquid assets. They have to be able to make adequate valuation of collateral in order to protect
their books, and, ultimately, taxpayers’ money. However, it is not easy to find the best method
for pricing highly sophisticated and complex financial assets which, in addition, do not or, at best
only have a very thin market either. Furthermore, as central banks start to act as market makers
without a reliable valuation model, their price indications, that can be perceived to lack a
fundamental valuation, can confuse market participants. In addition, the active role of central
banks in maintaining the liquidity of markets can prevent those markets from fast clearing thus
slow down the necessary re-adjustments. Another difficulty can be that, in my view, central banks
cannot easily quit from this market maker position.
Second, central banks also face serious moral hazard problems. Market participants may perceive
that central banks would also stand ready to provide funding liquidity and assist their
counterparties next time when they are engaged in even riskier operations aiming at higher yields.
It is difficult to find a balanced way for central banks to support the development and
functioning of new, fast-growing financial markets. Suitable haircuts and penalty rates can of
course help mitigate but not abolish moral hazard problems.
Third, present central bank practice provokes another concern, namely, how the solvency
position of banks having large portfolios of non-marketable assets in their balance sheets could
be judged. Liquidity squeeze can very rapidly turn into a solvency problem. This can call attention
for the revision of the liquidity management and capital requirements of banks.
Fourth, the broadening of the liquidity provisioning framework can have an effect on price
stability as well. Central banks should avoid the risk of increasing the monetary base permanently
to combat systemic liquidity problems that can counteract their primary goal to fight inflation.
However, to see the other side of the coin, I should mention some arguments for including less
liquid bank assets in the range of eligible collateral. In the absence of central bank support, fire
sales forced by the increasing liquidity preference of investors can drive asset prices well below
their fundamental value. Therefore, central bank measures could help decrease liquidity premia
and avoid substantial unfavourable repercussions of balance sheet deleveraging turning into
significant negative real economic developments. In addition, this time funding liquidity
problems were coupled and partly caused by market illiquidity. Therefore, Bagehot’s principle on
the liquidity of collateral could still be satisfied since under normal circumstances the new
collaterals can become liquid again.
Some cross-border issues
Let me continue my speech by discussing the cross-border perspective of this issue. The high
degree of financial integration has increased the risk of cross-border contagion. It is still not
decided which (the home or the host) central bank and in what extent is the responsible lender or
market maker of last resort. This problem can be more acute in the CEE region where the
majority of banks rely heavily on foreign funding and a significant part of their balance sheets is
denominated in euro. In our view, the only way to be prepared for the efficient management of
potential cross-border liquidity problems is to set up adequate cooperation structures at the
regional level and to co-operate at the regional and/or EU level in providing liquidity assistance
in euro. This could ensure intensive cross-border communication, both in normal times and in
emergency situations. As proposed by the EU-wide Memorandum of Understanding between
financial authorities1, a possible way forward could be the establishment of Cross-border Stability
groups and Voluntary Specific Cooperation Agreements.
To conclude my presentation, I should emphasise that the recent money market turmoil posed a
considerable challenge for central banks to re-design their monetary policy and financial stability
toolkit to mitigate the effects and keep the monetary transmission channels effective. However,
their primary objective to fight inflation has not changed but became even more relevant given
strong inflationary pressures from external and (in several countries) internal sources. Thus
central banks should find the narrow path of keeping inflation at low levels while following their
financial stability goals as well. The liquidity provisioning framework should be developed along
1Memorandum of Understanding on cooperation between the Financial Supervisory Authorities, Central Banks and
Finance Ministries of the European Union on cross-border financial crisis situations
these lines and used with prudence and flexibility avoiding high costs to taxpayers. I admit it will
be not an easy task in this new financial architecture, but I am confident that central bankers are
ready to meet these challenges.