Limits to What Lender of Last Resort Can Do
The acute phase of the financial crisis in 2008 showed central banks in their role of lender of last resort are unable to halt an opacity driven financial crisis by themselves.
This is quite a statement given the amount of patting themselves on the back central bankers have engaged in since the spring of 2009.
If you listen to the central bankers and other macro economists, you would think they had managed to halt the acute phase of the financial crisis. Nothing could be further from the truth.
As described in a Bundesbank discussion paper (Safe but Fragile: information acquisition, sponsor support and shadow bank runs), central banks went from being lenders of last resort to buyers of last resort in an effort to halt the opacity driven financial crisis.
The focus on these three measures is motivated by the policies that central banks and policy makers implemented during the financial crisis 2007-09 in order to shore up asset and funding markets. For example, beginning in Au- gust 2007, the US Federal Reserve (Fed) adopted a number of policy measures to shore up wholesale funding markets including the ABCP market. At first, “conventional” liquidity injections were implemented via a lowering of central bank discount rates and short-term repurchase transactions.20
These liquidity injections, however, failed to stop the precipitous fall in outstanding ABCP. They also did not prevent the run on money market funds that followed in the wake of Lehman Brother’s bankruptcy. Subsequently, in the fall of 2008, the US Treasury Department announced that it would temporarily guarantee all assets held by money market funds.
While this succeeded in stopping the run on money market funds, it failed to prop up the further collapsing ABCP market. This led the Fed to provide large amounts of non-recourse loans to commercial banks in order for them to purchase ABCP from money market funds. A few weeks later, the Fed also began purchasing commercial paper directly from issuers.21 These policy measures specifically targeting the ABCP market were also accompanied by outright purchases of asset-backed securities.22
20 In the euro area, the ECB injected 95e billion into overnight lending markets on August 9, 2007. Over the following days, the Fed followed suit and injected $62 billion. On September 18, 2007 the Fed supplemented these measures by launching the Term Auction Facility (TAF) which conducted longer- term repurchase transactions totaling $100 billion (Kacperczyk and Schnabl, 2010).
21 The non-recourse loans were administered by the Boston Fed’s liquidity facility (AMLF) and pur- chased roughly $150 billion worth of commercial paper in its first two week of activity. Outright debt purchases were carried out by the Commercial Paper Funding Facility (CPFF) which purchased over $300 billion worth of commercial paper. Through these two facilities, the Fed ended up holding about 25% of outstanding commercial paper by the end of 2008 (Kacperczyk and Schnabl, 2010).
22 The Fed extended non-recourse loans to buyers of both newly issued ABSs and legacy MBSs through its Term Asset-Backed Securities Loan facility (TALF) .
As regular readers know, the financial crisis occurred along the opacity fault line in the global financial system. Wherever there was opacity, the valuation story Wall Street told about these securities was called into doubt. Because investors could not verify this story, they stopped buying these securities (in fact, they tried to sell the securities, but there were few, if any, buyers).
The paper’s authors describe how the Fed ended up as the buyer of last resort. “Conventional” liquidity injections failed to stop the crisis. It simply moved on to the next opaque area of the financial system.
Notice footnote 21 where Fed ended up holding 25% of outstanding commercial paper and footnote 22 where Fed engaged in outright buying of newly issued ABS and legacy MBS. It purchased these opaque securities even though the Fed was like every other market participant and lacked the information necessary to value these securities.
There was no reason then or now to think central banks as a lender of last resort can stop an opacity driven financial crisis. What a lender of last resort can do is provide liquidity. It cannot provide confidence in the value of opaque securities.
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