The Hindu Business Line : Has Fed discounted the financial market crisis?

How does a central bank provide relief in the face of a financial market crisis? Does it act to provide liquidity on the liabilities side of the balance-sheet of financial intermediaries? Or does it perform the “lender of last resort” role and provide liquidity only on the asset side of the balance-sheets of lending institutions? How different is the provision of liquidity on the liabilities/asset sides respectively and what are the implications of the same? An d what is to be inferred from the provision of liquidity on different sides of the balance-sheet?

These questions have come to the fore following the US Federal Reserve’s move last Friday to lower its discount rate (at which it provides liquidity support to banks/other financial institutions) in the face of the squeeze in US credit markets/selling pressure in other financial asset markets, brought on by the sub-prime mortgage crisis.

Qualitatively different response

By acting on the discount rate alone, the Fed seems to have made a qualitatively different response to the financial market crisis. It appears to have broken with the past and could have set a precedent for the future. No longer can markets assume that the central bank will automatically engineer lower interest rates across the board for the entire system in response to a financial market meltdown.

The discount rate action, by providing liquidity on the asset side of the balance sheet, makes it available only to those market participants who actually need it.

Even during normal times, there is a certain reluctance on the part of depository institutions to avail of discount window credit, as it is perceived as a sign of weakness in their balance-sheets. Therefore, in a sense, the discount rate action is a localisation of the relief provided by the central bank.

To be sure, it is anybody’s guess if the discount rate action alone will suffice and the Fed will not be forced to lower interest rates in the entire system by cutting the Fed funds rate.

The three previous instances of financial markets breaking down in the US — the 1987 stock market crash, the 1998 LTCM crisis and in September 2001 after the terrorist attacks — were all marked by the Greenspan Fed aggressively cutting the Federal funds rate and thereby lowering interest rates for the entire system as the perception then was that the crisis from the financial markets would spill over into the real economy and derail economic growth.

Such a prospect (of the broader economy getting affected) has been recognised in the latest Fed action also but the Bernanke Fed has tried to steer a different path by acting on the discount rate alone. To that extent, there is the perception (and inference) that the broader economy may yet be shielded from the on-going problems in the financial markets and the need, therefore, is to persist with the prevailing overall level of interest rates in the system and target liquidity relief to institutions needing it.

Bail out, yet mitigated

It is still a bail-out for institutions that may be saddled with illiquid assets — which may have been acquired within the contours of a controlled risk-taking environment or could be positions acquired as part of excessive risk-taking. But the magnitude of the bail-out is mitigated by the fact that discount window credit will be available only for specified tenors.

Providing liquidity on the liability side of the balance-sheets of financial intermediaries, on the other hand, means that the central bank lays the foundation for an expansion of the aggregate volumes of lending/depositing in the financial system by permanently injecting central bank reserves and lowering market interest rates.

The expansion of the deposit base brings in liquidity on the liability side. Acting on interest rates with a view to finally impacting the asset and liability sides of lending institutions, therefore, represents a more permanent change of policy on the part of the central bank.

Overall, the discount rate action goes some way towards erasing the image of the central bank being ready to write a “put option” whenever the markets are in trouble. The market perceived the Greenspan Fed to have such a stance and the put option was therefore labelled the “Greenspan Put”. Indeed, some progress towards the erasure of the perception of a “Greenspan Put” could well be one of the beneficial by-products of the Fed’s response to the on-going financial market problems.

Monetary policy and asset bubbles

Another clear inference from the latest developments in global financial markets is that central banks are once again dealing with the consequences of “bursting asset market bubbles”. Globally, central banks have not preferred taking pre-emptive action to prick such bubbles.

Indeed, how and whether to incorporate asset prices — be it the prices of financial assets or of real assets such as houses — in the formulation and implementation of monetary policy is a complex and unresolved issue in central banking globally. It will be interesting to see how the contours of this debate takes shape after the latest market crisis brought about by “exuberant and excessive” asset prices in some sectors of the economy correcting severely.

The debate about whether central banks should act on interest rates to influence asset prices will necessarily and inevitably go on. But what strikes a market observer is whether interest rates are the only mechanism available to the central bank to influence asset prices.

The criticality of the central bank also acting as the supervisor and regulator of the banking system and performing that role to perfection comes to the fore here. As indicated earlier, the discount rate action would provide relief even to those lending institutions which have taken excessive risk positions in illiquid assets.

The question is: how and why could the central bank, during the course of its regular on-site and off-site supervision and surveillance of the lending activities of depository institutions, not detect these excessive and exuberant risk positions which were in effect a reflection only of the abnormal price levels in the underlying asset markets?

(Of course, the illiquid asset positions have not been confined to depository institutions under the regulatory jurisdiction of the Fed and include a range of non-bank institutions also. To that extent, then, there is a need for enlarging the official regulatory horizon to cover such institutions also).

The only inference can be that the Fed was eager to see that its regulatory initiatives did not stifle or make more costly innovation in the financial markets.

The Fed also possibly was complacent in the belief that the “invisible hand” of the market — meaning, self-regulation and the restraints on risk positions that a competitive market-place in itself imposes on financial institutions — would do the job.

It is quite clear that the markets alone have not done the job. And there is possibly a good case for the reiteration of the hybrid regulatory mechanism — where the market’s own regulatory initiatives blend with explicit official regulatory efforts.

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