The BIS quarterly review, which was published last week, provided some interesting thoughts on current liquidity and funding conditions (both secured and unsecured) — and how central bank transmission mechanisms have been affected as a result.
An important consideration, yet to be fully appreciated, is the divergence between private and public collateral and funding markets.
Simply put, back in the pre-crisis days the two markets worked in tandem. Participants engaging with the ECB did not differentiate on the type of collateral they delivered to the ECB versus the type of collateral they held back for use in private funding markets.
The crisis changed all of that.
Suddenly the cheapest collateral to deliver became the collateral of choice for ECB use. The most expensive or ‘quality’ collateral was held back for use in private markets.
A tale of two collateral markets
This is how central bank transmission mechanisms began to be compromised.
The private funding markets, dictated by interbank participants, could from now on only be influenced by large quality collateral holdings — which the central banks increasingly lacked. The public funding market, dictated by central banks, became the domain of trash collateral — which no one really cared about.
The central bank monopoly on the ultimate cost of money thus became based around access to trashy collateral, not quality collateral — which remained the preferred funding option for private markets.
Unfortunately, it’s private liquidity which ultimately determines the scale and depth of the eurozone crisis — and it’s in this market where ECB influence is waning:
From the BIS (our emphasis):
Official and private liquidity interact in various ways. One way to think about this interaction is the traditional money multiplier concept: by determining the risk-free short-term interest rate and the amount of funds available to settle payments through the central bank, official liquidity is the basis for private liquidity creation. In times of crisis, however, private liquidity tends to evaporate and global liquidity collapses into its official component – or, to use the money multiplier analogy, the multiplier falls to zero.
In those circumstances, global liquidity will crucially depend on individual banks’ access to official sector funding. This is particularly relevant when banks’ funding needs are in a foreign currency, constraining the ability of the domestic central bank to address liquidity shortages, as observed in late 2008.
There are important implications here. Private market liquidity preferences begin not only to dictate the cost of funding outside of the ECB, but also bring about important consequences in terms of monetary flows:
But the interactions between private and public liquidity are arguably more complex than this conventional view suggests. For instance, private capital flows may lead to foreign exchange reserve accumulation (increasing official liquidity), and the reinvestment of these reserves in the liquid assets of other countries may help to further ease financial conditions (increasing private liquidity). There are signs, for example, that the channelling of large reserve holdings into government securities can contribute to global liquidity conditions through its effect on yield levels (Graph 1, right-hand panel)
In other words they can begin to influence things like currency basis swap rates and via that foreign currency reserves, as flows head into markets deemed as offering ‘quality’ securities.
The BIS, having now realised that it’s not enough to just influence one part of the collateral funding market makes the following point:
First, policies need to take into account the full liquidity cycle – liquidity surges and their associated contributions to systemic risk as well as liquidity shortages or disruptions in the provision of private liquidity. Second, policy frameworks need to be sufficiently robust to uncertainty about the exact sources and impact of global liquidity surges and sufficiently flexible to address sudden shortages in liquidity conditions at the global level.
Another way of looking at it is to understand that the decision to replace private funding through central bank liquidity has only encouraged trashy collateral dumping in central banks — and heightened the divide between private markets and public markets.
The two are running increasingly off course. Unless central banks act collectively to re-establish control of quality collateral markets, no matter how much liquidity they provide against trashy collateral — it won’t make much of a difference.
Private markets must be convinced to lend unsecured or invest money in more than just the last few remaining AAA bond markets.
But as they say, you can lead a horse to liquidity but you can’t make it drink. Which is a shame, because that’s the main problem the ECB and other central banks are now facing: they are leading banks to liquidity but they can’t make them lend in private markets.
Le plan, negatifs taux d’intérêt, redux – FT Alphaville
One Eurobond to rule them all – FT Alphaville
The German bond market is all about ‘buy and hold’ – FT Alphaville
When a government bond becomes a Giffen good – FT Alphaville