Victor Mendez-Barreira: Central Banks and Banks: A Changed Relationship
2020-03-24 IMIThis article was first published by centralbanking.com written by Victor Mendez-Barreira. Click here to read the original article. Mr. Yaseen Anwar, Member of IMI International Committee, Former Governor of the State Bank of Pakistan, Senior Advisor of ICBC Singapore, contributed to this article.
The development of large, complex international capital markets has reshaped the relationship between central banks and their commercial counterparts Since the 1980s, the liberalisation of international capital movements, as well as the increased size and complexity of money markets, radically altered the interactions between central banks and commercial banks. The relationship further transformed in the wake of the global financial crisis as central banks embraced unconventional monetary policies, including negative rates, new lending operations and quantitative easing (QE). The result was central banks had to develop new capabilities to better understand financial markets, and do so in an efficient manner. This required central banks to engage more with market participants by seeking out knowledge transfers from banks, while also transforming themselves to behave in a manner more similar to other market counterparts. “The overriding change is that central banks are now much more aware of the need to understand markets, to be part of markets, and to behave like ordinary market players,” says John Nugée, former chief manager of reserves at the Bank of England and former head of official institutions at State Street Global Advisors. “If you go back far enough, you will find that central banks viewed markets with a little bit of disdain, a little bit of distrust and a very great lack of understanding.” In the 1960s and 1970s, central banks still ran their own money markets and banking systems by diktat. This was exemplified by the UK’s secondary banking crisis of 1973–75. A sharp fall in property prices left dozens of small lending banks on the brink of bankruptcy. “The UK solved that by basically telling solvent banks to lend to, or at least not foreclose on, insolvent banks. It was called ‘the lifeboats’. And it was done by BoE order,” says Nugée. Over two decades later, when dealing with the collapse of the hedge fund Long-Term Capital Management, the US Federal Reserve still exerted considerable influence over banks. Nonetheless, the relationship had already evolved. In 1998, the Federal Reserve Bank of New York co-ordinated an LTCM bailout of $3.6 billion, with contributions from major US banks, including Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch and Morgan Stanley, and even international institutions with a large US presence, such as Barclays, BNP Paribas and Deutsche Bank. But it had to offer incentives. “The Fed corralled all the banks and persuaded them together, but it had to sweeten the pot. It had to make it worthwhile,” says Nugée. In return for their support, the banks participating in the operation received a 90% share in the fund. “Nowadays, central banks know that they no longer have the ability to order banks to lend against their wishes.” Their earlier dominance meant central banks did not evolve their understanding of markets whose participants merely responded to their orders and had limited opportunity to impose their own perspectives. But the globalisation of finance and economics that followed since the 1980s, and the deregulatory policies underpinning both, demanded that central banks adapt. Global capital movements The transition first started with the end of the Bretton Woods era of fixed exchange rates in 1973. The ensuing elimination of capital controls contributed to the sharp rise in capital movements. For example, global capital flows rose from 8% of global GDP in 1990 to over 40% just before the financial crisis in 2007, researchers at the European Central Bank (ECB). Additionally, the liberalisation of financial regulation carried out in the US and the UK in the 1980s accelerated the process. “These changes allowed the creation of new derivatives products. It fostered the creation of hedge funds and other non-bank financial actors, as well as the expansion of areas such as foreign exchange markets,” says Yaseen Anwar, senior adviser at Industrial and Commercial Bank of China, in Singapore, and governor of the State Bank of Pakistan from 2011–14. “In the US, the repeal in 1999 of the Glass-Steagall Act [separating retail and investment banking] created fertile ground for a riskier and more complex financial environment, the development of which outpaced the required regulatory controls needed to mitigate the shocks and vulnerabilities to the international monetary system.” The current structure of the international monetary system makes it much more difficult to isolate one domestic market from the global market or from the forex market, says Nugée. As a result, a domestic crisis and a forex crisis can morph into the same thing. In an environment of greater capital flows and cross-border lending, sharp inflows as well as outflows of international investment became more acute. This exposed national authorities in emerging economies to an unforeseen external challenge that became apparent in the 1997 Asian financial crisis. Through the 1980s and 1990s, countries such as South Korea ran large current account deficits to finance the capital investment needed for their rapidly growing export-orientated industry. International investors sought to make the most of these higher-yielding industries, while limiting risk by lending in dollars at short maturities. However, once US growth started to accelerate in the mid-1990s and the Fed raised interest rates, its counterparts in Asia – whose currencies were pegged to the dollar – were also forced to raise rates. It resulted in appreciating currencies that ultimately hurt Asian export sectors. “The monetary policy implemented by developed economies was disconnected from the emerging market economies,” says Anwar. “Global factors that were not that threatening to international financial stability in previous decades became a focal point in large part due to the growing number of investors operating through this larger financial system.” Lower growth and higher unemployment sharply reduced incomes and tax revenues in Korea, Indonesia and Thailand. As the crisis escalated, borrowers were not able to repay their foreign currency debt, just as their access to external borrowing dried up and the value of domestic currencies plunged against the US dollar. Investors withdrew from the region, seeking refuge in the stronger dollar. “Whenever you have liberalisation and new developments, such as new markets opening up or new players entering the financial system, central banks must raise their game,” says Stefan Gerlach, chief economist at EFG Bank in Zurich and deputy governor at the Central Bank of Ireland from 2011–15. A richer toolkit If global capital movements and new financial actors limited the ability of central banks to foster stability, the 2007–09 financial crisis tested the effectiveness of their monetary policy tools. The response to the crisis resulted in central banks developing unconventional policies and new capabilities to effectively deploy them. These tools included new lending operations, negative rates and large asset purchases or QE. “The view before the financial crisis was that central banks only had to worry about one thing, and that was determining short-term nominal interest rates,” says Gerlach. “As they moved them up and down, the financial system would become more or less restrictive.” But the sudden and acute liquidity shortage in the US interbank market unleashed during the crisis diminished the ability of central banks to shape financial conditions through interest rates. Before the crisis, the scarcity of reserves meant that small changes in their supply would affect the federal funds rate. The US central bank managed rates with a corridor through open market operations. It exchanged Treasuries and cash with authorised banks, which borrowed cash at a ceiling rate, while cash deposited at the Fed always received zero interest. Once the interbank market dried up, financial institutions without direct access to the Fed’s balance sheet faced much higher costs to access liquidity than those borrowing from the central bank. In this new environment, setting an interest rate was not enough. “If the liquidity in the financial system is completely fluid, then the interest rate that you set will matter for everybody,” says Gerlach. “But if different players face different interest rates, you have to worry not just about short-term interest rates, and banks’ ability to borrow from you, but also about changing collateral and counterparty rules.” The Fed reacted by permitting new counterparties to borrow in its repo operations, among them investment funds and securities dealers. Additionally, as financial institutions requested ever-higher levels of liquidity, they ran out of adequate collateral such as Treasuries and other highly rated sovereign bonds. As a result, central banks also needed to broaden the spectrum of assets they accepted in their overnight operations. In Europe, where banks still play a dominant financial role, financial institutions faced new difficulties to access liquidity during the sovereign debt crisis in 2010–12. “The yield of the domestic government debt determines the floor at which banks can fund themselves,” says Gerlach. “If you were a bank in a country where the public debt is seen as risky, and suddenly saw bond yields rising, you may start to wonder about your ability to secure funding in the future.” Lending operations As banks kept struggling to fund themselves, central banks deployed new lending operations to directly support them. They increased the frequency of repo auctions, provided funds at longer maturities and created new liquidity facilities. For instance, in July 2008, the Fed created the Term Securities Lending Facility Operations Program (TOP). This offered primary dealers, institutions allowed to trade securities with the US government, the option of accessing additional liquidity during periods of higher demand through the Term Securities Lending Facility (TSLF). The Bank of Canada created two backstop facilities offering access to collateralised funding during the most acute phase of the crisis in 2008 and 2009, the Term Loan Facility (TLF) and the Term Purchase and Resale Agreement (TPRA). Some central banks set up new facilities to swap less liquid assets for Treasury securities, with the aim of providing financial institutions with liquid assets they could use as collateral to obtain cash in private repo markets. Examples of this are the Fed’s TSLF, from March 2008, and the BoE’s Special Liquidity Scheme (SLS), from April 2008. In addition to addressing market liquidity shortages, these new facilities also served as monetary policy tools. The Committee on the Global Financial System of the Bank for International Settlements (BIS) points out that with these facilities central banks aimed to limit uncertainty about the future evolution of the policy rate. Additionally, they wanted to improve funding conditions of banks, and foster credit creation through longer-term lending with conditions. One example of the latter is the ECB’s Targeted Longer-Term Refinancing Operations (TLTROs), launched in 2014. The ECB offers TLTROs to banks to help them to meet their funding requirements in the expectation they will extend financing to families and businesses. “By offering banks long-term funding at attractive conditions, they preserve favourable borrowing conditions for banks and stimulate bank lending to the real economy,” says the ECB on its website. In October 2019, a survey of central banks, carried out by a committee assessing TLTRO operations, said central banks reported that they’d helped to “ease liquidity strains, restore the monetary transmission channels, and alleviate pressures in bank funding markets”. Participants added that “these tools also took effect by reducing uncertainty about the future availability of liquidity, which would otherwise have hindered the market supply of funds”. Negative rates In the wake of the crisis, the Fed and the European Central Bank reduced rates to new record lows only slightly over 0%. Lower yields in the two main sovereign debt blocks put upward pressure on the exchange rates of smaller, high-income, open economies such as Sweden and Switzerland. In a bid to sustain growth and avoid deflation, the central banks of these countries had to offer negative rates. In July 2009, Sveriges Riksbank was the first central bank to introduce negative rates. Facing similar challenges, the Swiss National Bank cut rates below 0% in December 2014. By contrast, the ECB’s decision to lower its deposit rate down to -0.1% in June 2014 was not related to any exchange rate objective. The Eurosystem central bank eased monetary policy in a bid to anchor medium-term inflation expectations closer to its target. Negative rates are one of the most contentious points in the current relation between central banks and banks. In spite of their accommodative effect, there is a growing consensus around their limited effectiveness and negative side effects. “The debate is ongoing, but as time passes and people look back and evaluate the experience, they are becoming more inclined to highlight two problems with negative rates. The first one is basically that they are subject to diminishing returns,” says Claudio Borio, head of the monetary and economic department at the BIS. “The second is that the lower you go and the longer you stay there, the greater also the side effects that you might have.” One potential side effect has to do with financial stability concerns over a longer-term horizon. “They contribute to encouraging a greater search for yield. When returns are very low, since target returns tend to be rather sticky, investors go out and take on more risk in order to earn more money,” says Borio. The second type of risk is that “you might lull participants into a false sense of security”, he adds: “If you think, for example, that corporate spreads are very low but the central bank may be at the buying end, market participants might be inclined to think that the central bank will always be there as buyer of last resort. That would induce market participants to take on more risk.” Quantitative easing But record-low and negative rates proved insufficient, on their own, to boost growth after the financial crisis (or convincingly push prices towards inflation targets). This limitation, as well as reaching the effective lower bound, forced policy-makers to come up with new tools. Probably the most relevant was QE. Large asset purchase programmes (APPs) involved central banks dramatically expanding liquidity by purchasing sovereign and corporate debt as well as other assets from commercial banks and other counterparties in the secondary market. This provided additional monetary accommodation, boosting asset prices against a backdrop of deflationary pressures. Additionally, some QE programmes also targeted market functioning in order, for instance, to lower risk premia and improve market conditions. This is the case with the ECB’s programme. In January 2020, its holdings amounted to €2.6 trillion ($2.8 trillion), with €2.16 trillion of this invested in sovereign bonds. These acquisitions have contributed to reduce the risk premia between the sovereign debt of countries such as Italy and Spain compared with German Bunds. The sheer size of the policy experiment was bound to increase the role of commercial financial institutions in handling these assets. For instance, the total assets of the Federal Reserve increased from $870 billion in August 2007, to $4.5 trillion in January 2015, thanks to its QE programme. For example, BlackRock has supported the Federal Reserve, the ECB and the Bank of Japan by thinking through how their QE strategies can be most effective in calming asset-backed securities markets, or achieving lower long-term rates with a limited number of tools. “As these consultations are conducted through our Financial Markets Advisory practice, BlackRock can contribute completely free of conflict,” says Terrence Keeley, global head of BlackRock’s Official Institutions Group. “Whereas investment banks could not be advising central banks on which portion of the curve, or which parts of their credit markets, they should intervene in for maximum effect.” While commercial banks may contend this point, the rapid evolution of unconventional monetary policy has undoubtedly created increased business activities, be that for asset managers, custodians or banks. Because of QE, central banks “need to custody more assets than they used to”, says Daniel Zelikow, vice-chairman for the public sector at JP Morgan: “These assets have more diverse characteristics than in the past, including some that carry credit and market risks. As a result, JP Morgan is more active in providing liquidity to central banks to buy and sell a greater diversity of securities. We also help central banks hedge some of the financial risks they take on as they diversify their portfolios.” In Europe, Deutsche Bank works with five eurozone national central banks, helping them to lend securities they buy as part of the ECB’s QE programme in a bid to boost their returns. “Central banks have probably the strongest appetite of any client group that we see for market colour,” says Maurice Leo, director of agency securities lending at Deutsche Bank. “We are in ongoing engagement with central banks, much of it providing intellectual property on our side. We are sharing market perspectives and background around counterparty behaviour and trends in the sovereign and corporate repo markets that support the further operations and liquidity provided by the APP securities lending programmes.” Nonetheless, although QE opens new business opportunities and boosts the price of assets held by banks, as is the case with negative rates, it also hampers some of the key elements of commercial banks’ business models. “The fact that central banks bought long-dated securities, both Treasuries and mortgage-backed securities, means that they have a much more explicit and stronger role in the slope of the yield curve, and this is a key driver of profitability [for banks],” says Willem Buiter, former global chief economist at Citi and visiting professor at Columbia University. “Historically, banks make money borrowing short and lending long. By flattening out the yield curve, that particular channel of profitability has been severely impaired, especially in the eurozone and Japan.” The fact that this typically profitable arbitrage is no longer as lucrative as it was has resulted in most banks and other institutions taking greater risks, putting risky assets on the balance sheet in an attempt to break out of this low profitability, adds Buiter. Following a pause in 2019, the ECB restarted its QE programme in November 2019 at a rate of €20 billion in purchases per month. This open-ended phase may make the ECB reach its self-imposed limits on the share of sovereign debt it may buy from each country. This could open the programme to new assets. “In the euro area, I can see the ECB investing in equities, as we run into the capital key and the issuer limit constrains,” says Buiter. “Bank debt is problematic because it creates direct tension between a central bank’s role as supplier of liquidity, lender of last resort and its regulatory/supervisory function.” But such a shift in central bank purchases could result in a reduction in opportunities for others across a broader spectrum of financial instruments, including corporate bonds, corporate equity and exchange-traded funds. Central banks have increasingly relied on their commercial counterparts to better understand financial markets during the past few decades. Now, however, they are causing major distortions in these markets – which, in turn, look set to hit their commercial counterparts.