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5 Central bank impotence and market
liquidity By Henry C K Liu
the short-term rate close to the
Fed's target. The discount rate affects cost of
funds without affecting money supply while the Fed
Funds rate changes the level of the money supply.
Both rates are set by fiat by the Fed based on the
Fed's best judgment within its theoretical
preference.
The difference between the two
rates is that the discount rate is set
independently of market forces, while the Fed
Funds rate acts
through market forces. With
the discount rate, the Fed sets the rules of the
money market game while with the Fed Funds rate,
the Fed acts as a key money market participant.
In response to the October 19, 1987,
crash, Alan Greenspan, as the newly appointed Fed
chairman, lowered the Fed Funds rate from 7.25%
set on September 4, 1987, 45 days before the
crash, to 6.5% by early February, 1988, while
keeping the discount rate at 6%. On February 23,
the Fed increased the spread to 3-1/8 percentage
points with the Fed Fund rate at 9-5/8% and the
discount rate at 6-1/2%. The Fed then lowered both
rates gradually to 3% with zero spread by
September 4, 1992, below the inflation rate for
August which was 3.15%.
The negative
interest rate launched the debt bubble that first
fueled the tech bubble which peaked on March 10,
2000, and burst in subsequent months when
Greenspan raised the Fed Funds rate to 6.5% on May
16 and the discount rate to 6% before lowering
rates starting January 3, 2001, to save the
market. By November 6, 2002, the Fed Funds rate
was 1.25% and the discount rate was 0.75% to fuel
the housing bubble which was also turbocharged by
subprime mortgage securitization. That housing
bubble is now bursting.
Until January 3,
2003, the discount rate normally was set at 25 to
50 basis points below the Fed Funds rate. On that
historic day, the discount rate was reset by
policy to be 100 basis points above the Fed funds
rate. On June 25, 2003, when the Fed Funds rate
was at a historical low of 1%, the discount rate
was set at 2% when the inflation rate was 2.11%.
Negative interest rate expanded the housing bubble
in a frenzy rate.
Before 2003, to prevent
banks from exploiting the spread between the Fed
Funds rate and the then lower discount rate, the
Fed required banks to document any need for funds
as appropriate to the discount facilities' policy
intent. Discount window loans would not be granted
as bridge loans to enable banks to wrap up planned
investment or to exploit loan opportunities beyond
the bank's normal liquidity range. In addition,
banks were expected to have first exhausted all
other reasonable sources of credit before
borrowing from the discount window and should
expect to face greater regulatory scrutiny if they
borrow at the window too frequently. These
non-pecuniary penalties made many banks reluctant
to borrow at the discount window for adjustment
credit, concerned over a perceived "negative
signal" that such action would send. The volume of
borrowed reserves was generally less than 1% of
total reserves.
Setting the discount rate
above the federal funds rate target was an
important change in the administration of the
discount window to allow for more reliance on
explicit market pricing to determine the volume of
discount window borrowing and to remove the
perceived stigma to discount borrowing.
Eligibility requirements would be streamlined and
rendered consistent with reliance on the discount
window as a relatively unfettered source of
liquidity for financially sound banks during tight
money market conditions that would otherwise
result in a spike in the Fed Funds rate.
The initial proposal set a cap for the
discount rate at 100 basis points above the
federal funds rate target. Historically, this cap
would have been breached by the average daily
federal funds rate only about 1% of the time, with
roughly half of those days coming on bank
settlement days. However, the frequency with which
individual trades throughout the day would have
exceeded the cap was significantly higher. The
closing Fed Funds rate would have exceeded this
cap approximately 4% of the time. As banks
adjusted their reserve management practices under
the new operating procedures, this cap became
binding more frequently than history would
suggest. In any case, the average daily cost of
federal funds to banks should be reduced and the
Federal Funds rate should remain closer to the
Fed's target.
This rule change on the
discount rate was expected to have several
benefits. First, providing a cap on the federal
funds rate by endogenously supplying reserves to
meet high periods of demand should reduce interest
rate volatility. This might become more
significant as continual financial innovation
would otherwise further reduce banks' required
reserves and render the demand for reserves more
interest inelastic, as required clearing balances
assume a larger share of the total demand for
reserves. Second, the simplification of discount
window borrowing procedures should lead to reduced
administrative costs and streamline operations.
Third, these simplifications also will help
clarify the intent of individual discount window
regulatory decisions, since less subjective
assessment is required. Finally, monetary policy
could be rendered more effective, to the extent
that the discount rate could become a tool for
capping the federal funds rate. This cap could be
adjusted to keep the Fed Funds rate close to the
target value, where "close" is determined as a
matter of monetary policy decisions that reflect
current market conditions. In Fed newspeak, the
"discount" rate then becomes more expensive than
full price inter-bank borrowing.
Primary and secondary credit On
January 9, 2003, the Fed adopted this procedure
and introduced two levels of discount rate:
primary and secondary. Primary credit is available
to generally sound depository institutions on a
very short term basis, typically overnight, at a
rate above the Fed Open Market Committee's target
rate for federal funds. Depository institutions
are not required to seek alternative sources of
funds before requesting occasional short-term
advances of primary credit.
The Fed
expects that, given the above-market pricing of
primary credit, institutions will use the discount
window as a backup rather than a regular source of
funding. In reality, as the debt economy
developed, banks were able to use the discount
widow without regulatory scrutiny to fund planned
investment or loan opportunities that yielded
returns higher than the punitive discount rate.
The Fed in effect became a funding agency of last
resort for the debt bubble.
Primary credit
may be used by banks for any purpose, including
financing the sale of federal funds. By making
funds readily available at the primary credit rate
when there is a temporary shortage of liquidity in
the banking system, thus capping the actual
federal funds rate at or close to the primary
credit rate, the primary credit program
complements open market operations in the
implementation of monetary policy.
Primary
credit may be extended for up to a few weeks to
depository institutions in sound financial
condition that cannot obtain temporary funds in
the market at reasonable terms; normally, these
are small institutions. Longer-term extensions are
supposedly subject to increased administration. It
is not clear if the Fed's new term of up to 30
days involves increased administration to subject
borrowing banks to greater regulatory scrutiny.
Secondary credit is available to
depository institutions not eligible for primary
credit. It is extended on a very short-term basis,
typically overnight, at a rate that is above the
primary credit rate. Secondary credit is available
to meet backup liquidity needs when its use is
consistent with a timely return to a reliance on
market sources of funding or the orderly
resolution of a troubled institution. Secondary
credit may not be used to fund an expansion of the
borrower's assets. The secondary credit program
entails a higher level of Reserve Bank
administration and oversight than the primary
credit program. The Fed will require sufficient
information about a borrower's financial condition
and reasons for borrowing to ensure that an
extension of secondary credit is consistent with
the purpose of the facility.
Effect of
discount borrowing controversial Discount
window borrowing is sensitive to the spread
between the Fed Funds rate and the discount rate.
As the spread narrows, discount window borrowing
can be expected to increase. Hence, discount
window borrowing would offset, at least in part,
the effect of open market operations on reserve
supply. The effect of this feature of discount
window borrowing remains controversial even after
an indeterminate debate in 1960 among economists
on whether the discount mechanism offsets, as
argued by Milton Friedman, or reinforces, as
counter-argued by Paul Samuelson, the monetary
policy objectives of the Fed.
Discount
borrowing stigma During the early 1990s,
borrowing from the discount window fell
significantly, averaging only $233 million, even
though this was a period of banking system stress.
Stavros Peristiani, assistant vice president in
the banking studies function at the Federal
Reserve Bank of New York, whose primary areas of
research include housing finance, mortgage-backed
securities, bank mergers and acquisitions,
discount window borrowing, and initial public
offerings, argues that this decline may have been
due to banks refraining from requesting discount
loans because of the perception that it would send
a negative signal to the Federal Reserve, bank
supervisors, and eventually the market at large.
Even when banks' financial conditions improved in
the mid-1990s, banks remained reluctant to borrow
from the Fed.
Partly to address this
reluctance, the Fed replaced its adjustment and
extended credit programs with the new primary and
secondary credit facilities. Now, banks in good
financial condition could borrow from the Federal
Reserve capped at 100 basis points above the Fed
Funds rate target. The above-market price of funds
serves as a rationing mechanism that dramatically
reduces the need for supervisory review of the
potential borrower. Because use of the new primary
credit facility would not necessarily imply
anything negative about a borrower, bunks should
be more willing to use the facility if market or
bank-specific conditions warranted.
In
fact, since the implementation of this new
facility, banking supervisors have specifically
announced that "occasional use of
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