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					SIEPR brief
                                                                       Stanford University • November 2008

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Unblocking Credit Markets by                                                About The Author

Reducing Counterparty Risk                                                  Ronald McKinnon is the
                                                                            William D. Eberle Professor
                                                                             of International Economics
By Ronald McKinnon                                                          at Stanford University,
                                                                            where he has taught since
    The U.S. Treasury’s $700            pean lead providing public          1961. He is also a SIEPR/SCID
billion Troubled Asset Relief           funds to recapitalize banks,        Senior Fellow.
Program (TARP), announced               insurance companies, and            His fields of interest are international
on September 19, was cobbled            a few other key players in          economics and development finance.
together in great haste. Its            the credit markets; although        McKinnon has written over 100 articles and
ostensible primary mission              these are de-capitalized now,       several books, which include: Money and
is (1) to buy difficult-to-value        they have a chance of being         Capital in Economic Development (1973); Money
mortgages still held by banks           solvent once the current crisis     in International Exchange: The Convertible-

and (2) to buy even more                is over. The U.S. Treasury          Currency System (1979); The Order of Economic

difficult-to-value mortgage                                                 Liberalization: Financial Control in the Transition
                                        now realizes this. As an-
                                                                            to a Market Economy, 1993; The Rules of the
and other asset-backed                  nounced on October 27, $125
                                                                            Game: International Money and Exchange
securities sliced into various          billion of TARP money will          Rates, 1996; Dollar and Yen: Resolving Economic
risk tranches and distributed           be used to recapitalize seven       Conflict Between the United States and Japan
widely throughout both the              more banks. This is a neces-        (with Kenichi Ohno), 1997; and Exchange Rates
U.S. and European financial
                                        sary condition for reducing         under the East Asian Dollar Standard: Living with
systems. Mission impossible!                                                Conflicted Virtue, in 2005.
                                        the severe counterparty risk,
More subtle approaches
                                        which has caused the key            His books have been translated into many
are required to quash the
                                        interbank and commercial bill       European and Asian languages, and he
counterparty risk that plagues
                                        markets in the United States        has been a consultant to central banks and
the financial markets.                                                      finance ministries the world over-including
                                        and Europe to seize up.
    The United States would                                                 international agencies such as the World Bank
be better to follow the Euro-           continued on inside...              and International Monetary Fund.
SIEPR policy brief
(Partial public ownership                 in recent decades by the                   to safety, by both traders in
of the banks can also be a                Taylor rule (Taylor 1993). In              the interbank markets and
lever for introducing more                crises, the CB may also lend               foreign central banks hold-
permanent and much-needed                 to distressed bank borrowers               ing dollar exchange reserves,
regulatory reforms, a story for           through its discount window,               depresses the yield on short-
another time.)                            though traditionally at a                  term Treasury bonds (less than
   Although recapitalizing                penalty rate.                              one month) to less than 0.5
banks is necessary in the long                In the current crisis, the             percent.
run, this step is not sufficient          Fed has — very unwisely as                     Government officials now
to quash counterparty risk                we shall see — driven the                  complain that commercial bank
in the near term. Uncer-                  federal funds rate toward                  lending to nonfinancial firms,
tainty about the adequacy and             zero. The Fed has also lent                despite extensive bank recapi-
permanence of the recapital-              massively both through its                 talization, is inadequate. Thus,
ization process is so great that          discount window and by                     on October 27, the Fed itself
additional, more direct institu-          holding auctions to buy less-              started buying commercial bills
tional measures are needed.               than-prime securities from                 directly from the private sector.
I propose that central banks              private banks. These serve                 But this new strategy is fraught
act as broker-dealers in the              to pump short-term liquid-                 with moral hazard. Many of the
huge interbank markets to                 ity, perhaps in excess, into               new sellers of commercial bills
borrow and lend at different              the system but don’t directly              to the Fed — Morgan Stanley,
terms to maturity1.                       deal with counterparty risk in             UBS, and the finance arms of
                                          transacting between private                General Electric and General
A New “Market Maker”                      banks. What is the evidence?               Motors — are themselves finan-
Window for Central Banks                  Insofar as there is interbank              cial firms in some distress. And
    Traditionally, in mature              trading in London, the LIBOR               no doubt many more distressed
industrial economies, the cen-            remains two percentage                     borrowers with political clout
tral bank’s (CB’s) role is one            points or more higher that                 will soon appear.
of controlling some short-term            the federal funds target rate                  Instead, a resumption of
interest rates — bank rate,               of 1 percent. Also, traders                normal private bank credit
federal funds rate — to target            complain that U.S. Treasury                to large and small industrial
macroeconomic variables                   bonds, the prime and now                   firms is needed to prevent
such as the exchange rate in              the only acceptable collateral             a sharp decline in domestic
the 19th century (Bagehot                 in interbank lending, are still            output. But a necessary
1879) or domestic inflation               in short supply. The flight                lubricant is parallel borrowing

1 This proposal is similar to that put forward by Jan Kregel (2008), but the details are quite different.
and lending free of counter-      banks are now sufficiently        the slope might initially be
party risk in the interbank       well equipped to act as           quite steep — with long rates
market. Counterparty risk         broker-dealers in their respec-   as much as three percentage
naturally rises with the term     tive interbank markets — but      points higher than short
to maturity of the interbank      with one further change in        rates, as in today’s Treasury
loan. Even if bank A was          their mind-sets. Traditionally,   bond markets. But now
fairly sure that bank B could     commercial bank reserves          counterparty risk would have
repay a collateralized over-      with the CB have been             been eliminated because
night loan, a three-month or      treated as short-term sight       commercial banks, as either
six-month loan would carry a      deposits withdrawable on          borrowers or depositors, deal
higher probability that bank      demand, which makes sense         only with the CB — which is
B would default. Thus inter-      if the commercial bank in         assuming all the default risk.
bank transacting has seized       question has an unexpected           Let us call this new
up more at longer terms to        liquidity squeeze. However,       facility the market maker
maturity. However, it is active   to more or less replicate         (MM) window.
interbank transacting at these    conditions in the pre-crisis
longer terms to maturity that     interbank market, each central    Rehabilitating the Real
facilitates normal commercial     bank would continue to            Bills doctrine
lending of three to six months    accept sight deposits while,          For this new MM window
or more for vital working         in addition, accept interest-     for lending to commercial
capital to the nonbank busi-      bearing-term deposits for 30,     banks at market interest rates,
ness sector — or even for         60, 90 days up to a year.         the CB would have to develop
fixed XXX(?) term lending to          On the asset side of          its own rules for acceptable
households.                       the CB’s balance sheet, it        collateral. But, unlike the
    What should central banks     would lend to credit-worthy       current stressed state of the
do? The recent TARP bill          commercial banks at similar       private interbank markets
carried with it a little-known    terms to maturity. Like the       where only U.S. Treasuries are
provision that allows the Fed     mythical Walrasian auctioneer,    acceptable as prime collateral,
to pay interest on commercial     the CB would determine            the CB should accept a broad-
bank reserves held with it.       interest rates to just balance    er range of high-quality private
The ECB already pays interest     the flow of funds at each         credit instruments. Indeed, the
on required commercial bank       term — with a small bid-          CB could well adopt a modern
reserves but only recently        ask spread. The yield curve       version of the old “real bills”
introduced a rule that allows     would slope upward in the         doctrine: Only documentary
it to pay interest on excess      normal way — although in          evidence of new, high-quality
reserves. These two central       today’s stressed environment      commercial bank lending to
                                                                     Stanford University • November 2008

the nonfinancial sector for       that continually increase the          Now consider what would
industry and trade would          supply of Treasuries, the new       happen if our MM window
qualify for a loan through this   safe-haven demand has been          were suddenly opened.
new MM window.                    so great that interest rates on     Then deposits at the central
   By overcoming the appall-      Treasuries have been driven         bank, a government agency,
ing reluctance of commercial      to very low levels, particularly    would be virtually as good
banks to lend to nonbanks         at short term: less than 0.5        as holding Treasury bonds at
despite huge injections of        percent on those with maturi-       different terms to maturity.
public capital, this new MM       ties of three months or less.       The demand for short-term
window would indeed grease        An important part of this           Treasuries would fall sharply
the wheels of industry. Be-       surge in demand is because          so that their yield would
cause interest rates would be     only short-term Treasuries          rise — as more money was
set high enough to balance        are acceptable collateral in        funneled into lending to the
the flow of funds at every        interbank transacting. And          private sector. Now the slope
term to maturity, the project     traders have complained             of the yield curve would
would be self-financing           about absolute shortages of         be more normal, i.e., less
without the inordinate public     Treasuries.                         steep. We would get a new
subsidies characteristic of           Both the Fed and the            equilibrium where foreign
recent financial bailouts.        ECB have recognized this            central banks were the main
                                  shortage and have engaged           holders of Treasuries, while
Eliminating the “Shortage”        in elaborate operations             domestic banks held surplus
of Treasury Bonds                 of swapping government              funds at interest with the
   In the current crisis, the     bonds for less secure private       Fed, or with the ECB in euro
upsurge in counterparty           instruments. Beginning last         transacting.
risk is largely due to the        March 12, the Fed began
distribution of opaque mort-      a $200 billion swap of              The Perils of Near-
gage-backed securities            Treasuries out of its own           Zero Interest Rates: A
throughout the financial          portfolio, which has since          Concluding Note
system. The resulting flight      had to be replenished by the           The genesis of the current
to safety, both by private        Treasury. Nevertheless, the         crisis is a seizing up of the
financial actors and by foreign   amounts proved insufficient         credit markets because of the
central banks holding official    to overcome the shortage of         counterparty risk arising out
exchange reserves, has re-        collateral in private interbank     of the collapse of the U.S.
sulted in a huge new demand       markets, in part because            housing bubble. It has spread
for “safe” U.S. Treasuries. De-   foreign central banks became
spite high U.S. fiscal deficits   such big buyers of Treasuries.      continued on flap...
into credit markets, such as     liquid banks. If short-term          commercial lending to the
the interbank market, not        deposit rates at the Fed must        nonbank sector — as Japan
so directly associated with      be less than the Fed funds           has found to its sorrow over
housing. The Pavlov response     rate of 1 percent (to prevent        the last 15 years.
of the Fed has been, among       round tripping), then banks
other more constructive          with liquid cash won’t bother        References
moves, to keep cutting the       depositing with the MM
federal funds rate so it ap-     facility because the yield is so     Bagehot, Walter, Lombard
proaches zero — now only         derisory.                            Street, BiblioBazaar, 1879.
1 percent. But this ultra low        In contrast, the ECB with
                                                                      Kregel, Jan, “A Simple
federal funds rate makes it      its target lending rate of 3.25
                                                                      Proposal to Resolve the
harder to restore normality      percent and the Bank of
                                                                      Disruption of Counterparty
to the flow of funds in the      England with a target rate of
frozen private credit markets.   3.percent are in better shape        Risk in Short-Term Credit
    First, the mutual distrust   to introduce MM windows that         Markets,” Policy Note, Levy
in the credit markets would      could offer attractive deposit       Institute of Bard College,
exist at any moderate level      rates that are slightly less than    2008/4.
of interest rates — and is       these target loan rates.
                                                                      Taylor, John, “Discretion
not relaxed by cutting them.         In summary, in the pres-
                                                                      Versus Policy Rules in
Second, the ultra low U.S.       ence of counterparty risk,
federal funds rate means that    letting interest rates fall toward   Practice,” Carnegie-Rochester
our hypothetical MM window       zero is counterproductive in         Conference Series on Public
would work less well in          unblocking interbank transact-       Policy, vol. 39, 1993, pp.
attracting surplus cash from     ing — and in restarting normal       195-214.
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