A question of safe assets : The paradox of unconventional monetary policy

We are now some 5 years into this crisis and we have witnessed some non-text book interventions in terms of substantial large amounts. Having a look at how balance sheets of central banks have exploded, it's really "de jamais vue", in some cases interventions in between 25% and 30% of GDP. It started out with the FED's Tarp and quantitative easing programs, later on followed by operation Twist 1 and now 2. The ECB in the meantime had 2 LTRO operations sized 1,000 bio EUR and a smaller version of QE with an SMP sized some 250 bio EUR in distressed bond buying. But it has been a while since they have stepped up purchases on this front. Since 29/06, it could well be the case that we will see some action resuming on this front if market circumstances should require. And Draghi will keep his promise with a rate cut tomorrow - after the political deal on 29/06 - and may be even surprising the markets (cfr latest Bloomberg survey) by setting the central bank deposit rate at 0%.

A lot of articles and points of view have been circulating lately on these unconventional measures, pros and cons. The best one I have read so far comes from Manmohan Singh and Peter Stella and it basically tackles the heart of the current money multiplier mechanism and counterparty risk in today's world of modern finance :

http://www.voxeu.org/article/other-deleveraging-what-economists-need-know-about-modern-money-creation-process

The authors basically explain the importance of collateral and trust in the present form of money creation. Interbank lending is of a vital importance and hence trust (counter party risk). And banks usually only lend to one another if some form of collateral is pledged, and perceived as safe collateral if remotely possible. And here we have already one distinction between classic textbook 101 money multiplier explanation and the current state of play :

To put it differently, a key difference between the trade and pledge-collateral credit creation processes is the role of governments. The traditional textbook money multiplier is based on insured deposits and thus largely a creature of government regulation and the central bank’s lender of last resort assurance. The collateral multiplier is very much a creature of the market. The multiplier – which essentially measures how efficient illiquid assets can be converted into liquid collateral and thus credit – varies with the extent to which markets views a given asset classes as ‘liquid’ in normal and stressed markets.

This is in fact a vital given. It also explains for example why German 2 year notes were recently sold @ a negative interest rate and were largely oversubscribed : in today's world of modern finance - where repo transactions are vital for creating credit and leverage - you simply need safe assets if you want to create some financial illusion. Finally, in this game, collateral can be repledged (bank A towards bank B where bank B uses the collateral received from bank A in a trade with bank C and soforth...)

Now we come to a second important point and it is linked to what the FED and ECB have been doing over the past couple of years in key policy interventions :

In this new private-money-creation process, there are three distinct ways of reducing credit.

- Increase the haircut (like raising the reserve requirement); this means that the trade should be overcollateralized or that for borrowing 100 you should pledge 110 or more

- Reduce the supply of assets that can be used for pledging

- Reduce the re-pledging of pledged collateral (shortening the collateral chain).

Most recent research has focused on the first. Balance sheet shrinkage due to ‘price declines’ (i.e., increased haircuts) has been studied extensively – including the recent April 2012 Global Financial Stability Report of the IMF and the European Banking Association recapitalisation study (2011). In this column we raise the flag on the second and (more importantly) the third way. When market tensions rise – especially when the health of banks comes under a shadow – holders of pledged collateral may not want to onward pledge to other banks.

- With fewer trusted counterparties in the market owing to elevated counterparty risk, this leads to stranded liquidity pools, incomplete markets, idle collateral and shorter collateral chains, missed trades and deleveraging.

- In practical terms, the ratio of pledged-collateral (which is a measure of the credit thus created) to underlying assets falls as this onward pledging, or interconnectedness, of the banking system shrinks.

Now what has happened over the past few years and what was the purpose ? With quantitative easing, the FED's intention was to lower interest rates by buying up US Treasuries, so called safe assets. The logic being that once interest rates move lower, the credit engine would ignite again. Alas it didn't. The FED first shored up 30% of virtually all US Treasury bonds in between 2 and 6 year maturity. Then came Twist were shorter maturity bonds were swapped for longer ones. But it basically means that you are draining a market from potential collateral to operate in the credit cycle. And if counterparty risk is still an issue, then you really don't solve the problem. On the contrary, paradoxically you make matters worse : Bernanke - in his efforts to avoid deflation - is creating deflationary tendencies by deleveraging the financial sector, this by reducing the supply of pledgeable assets !

In Europe, it's basically a same kind of logic, not in the mechanics but certainly in the results. The ECB so far was relatively modest in QE intervention when compared to other central banks worldwide. And it restricted its QE SMP program to buying up GIIPS bonds. But the result of all this in a market environment of counterparty risk and mistrust, is that everybody is holding on to his quality collateral and that no one accepts anything less in quality when performing repo trades. So also here, the system breakes down by lack of collateral willing to circulate (also because the inferior one is being banned from the system). Basically, the market comes to a halt and you have a liquidity crisis certainly with those being short of quality collateral. So in steps the ECB and announces unlimited liquidity provision for those in need and lowers its quality standards for accepting collateral (the only possibility because those in need have no longer acceptable collateral to pledge).

Finally, to conclude : Recent official sector efforts such as ECB’s ‘flexibility’ (and the ELA programs of national central banks in the Eurozone) in accepting ‘bad’ collateral attempts to keep the good/bad collateral ratio in the market higher than otherwise. But, if such moves become part of the central banker’s standard toolkit, the fiscal aspects and risks associated with such policies cannot be ignored. By so doing, the central banks have interposed themselves as risk-taking intermediaries with the potential to bring significant unintended consequences

And though this last statement of the article doesn't specifically mention it, it briefly also implies : central banks today are having a decisive impact on disfunctional markets, to the extent they are making markets redundant in the end. In the end, the central bank is the monopolist market maker for various asset classes.