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Vice President, Research
THE STUDY IN BRIEF
As lender of last resort, the Bank of Canada has the responsibility of stepping in to provide liquidity in cases when markets require emergency funding. In crisis situations, a timely and effective response is imperative for avoiding systemic breakdowns. In this Commentary, I argue that in order to achieve this goal, a predefined, permanent, market-wide emergency liquidity mechanism should be established. The benefits of such a mechanism, including on-going design improvement and transparency for market participants, outweigh concerns over the moral hazard it may generate.
The financial crisis of 2008-09 led to a new set of reforms through the Basel III regulatory framework. These rules have provided stability, including by limiting risky behaviour by financial institutions. However, they have also created a significantly smaller market for liquidity. Therefore, in future times of stress, financial institutions will face increased difficulty obtaining funding from private markets. Furthermore, as technologies become more sophisticated, idiosyncratic shocks can propagate into systemic shocks faster than ever before.
Combined, these concerns suggest the need for pre-established, non-discretionary, market-wide emergency liquidity facilities that are instantly available in times of crisis. The permanence of such facilities would allow the design to be improved as market conditions evolve, while the removal of discretion would increase the level of transparency that is vital for a well-functioning financial sector.
While the design of the emergency liquidity features introduced by the Bank of Canada during the 2008-09 global economic crisis was appropriate, the auction format used likely fell short of generating the competitive prices and quantities that create both optimal liquidity distribution and the highest possible return for the public. In this paper, I recommend the use of the "Product-Mix" auction design, which involves an unlimited bid, single-round process in which bids are made on different forms of collateral simultaneously, and no minimum reference price above the benchmark overnight rate is established in advance. The Bank should continue to use discriminatory pricing for different term repos and uniform pricing for term loan facilities. Overall, these characteristics should improve the outcome of any future auctions from the viewpoint of both financial institutions and central bankers.
C.D. Howe Institute Commentary[c] is a periodic analysis of, and commentary on, current public policy issues. Barry Norris and James Fleming edited the manuscript; Yang Zhao prepared it for publication. As with all Institute publications, the views expressed here are those of the author and do not necessarily reflect the opinions of the Institute's members or Board of Directors. Quotation with appropriate credit is permissible.
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In the wake of the Great Recession, it has become common to ask what policies should be in place to prevent any future financial stress from becoming a full-blown crisis.
Providing a liquidity and funding backstop is a key responsibility of the authorities as part of crisis preparedness. One lesson from the recent systemic stress on the financial system is that there should be no delay getting liquidity to market. Although a lack of liquidity might not be the cause of a given crisis, its loss in the aftermath of major negative shocks has severe and long-lasting consequences.
From the onset of the 2008 financial crisis, central banks across the developed world used different forms of extraordinary liquidity facilities, in many cases temporary, in an attempt to provide much-needed liquidity, stimulate credit markets and get the economy back on track. The scramble to provide liquidity demonstrated the need to establish market-wide, predefined emergency liquidity mechanisms to respond to any future financial crisis. Regrettably, although the Bank of Canada reserves the right to bring back the measures introduced during the crisis, this discretionary approach to policy makes it difficult from a transparency perspective to assess crisis preparedness, and impairs the ability to improve its ongoing design.
Since the crisis, bank regulations have changed, but the new policies are untested in crisis conditions. In addition, the federal government has adopted a different approach to its willingness to assume risk in the housing sector, (1) and has changed its approach to emergency liquidity backstops for major provincial institutions. Furthermore, a major concern regarding the next crisis is the speed with which a negative shock will be propagated to all financial institutions and to the economy as a whole. Without a clear understanding of when market-wide emergency liquidity measures will be available, financial institutions are left in the dark. Lessons from the crisis, and these developments since, call for changes to the approach of Canadian authorities to crisis liquidity arrangements.
At the detailed design level, any emergency mechanism should, as a first-order concern, ensure the central bank (or other facility provider) is helping to reestablish financial markets and financial market stability while not incurring unmanageable amounts of risk or compromising monetary policy objectives. A second-order issue would be the receipt of a competitive price for a given quantity of funding, which ought to generate the appropriate distribution of liquidity among bidders. (2)
The ideal emergency liquidity facility should (i) provide market-wide funding with no significant restrictions on potential financial institution bidders beyond what is laid out in the Bank of Canada's financial crisis facilities, (ii) give eligible institutions an unlimited number of bids, (iii) be done in a timely fashion with no preset minimum above the benchmark overnight rate, and (iv) be long-term backed by a variety of different forms of collateral. To address these issues, I argue that the "Product-Mix" auction design (see Klemperer 2010) should be used. With a lack of quantitative analysis available on the effects of uniform pricing, as Klemperer (2010) advocates, versus discriminatory pricing, the Bank of Canada should continue to use its discriminatory pricing approach for its term repurchase (term repo) (3) facilities and uniform pricing for its term loan facilities.
Lastly, in terms of restrictions, the federal government recently changed its policy so that major provincial credit unions will be able to access emergency liquidity only if the provincial government provides the Bank of Canada an open-ended indemnity. Several of these institutions are large enough to have systemic consequences in a crisis, and it is highly desirable that these arrangements be in place before any crisis hits. None of these arrangements are currently in place, however, so the federal authorities should provide more transparency on the liquidity arrangements these institutions would have access to in a crisis in order to encourage the provinces to sign on.
My overall recommendations, therefore, are as follows:
* the emergency liquidity facilities introduced during the financial crisis should be made permanent, rather than discretionary, and possible moral hazard problems should be dealt with through the design of the arrangements and other measures;
* the provinces and the Bank of Canada should actively discuss arrangements that would apply to major systemic provincial institutions in the event of a crisis, and enter into the necessary indemnity and loss-sharing arrangements as soon as possible;
* the authorities should undertake further studies as part of their financial stability responsibilities on how various severe liquidity and funding scenarios might be handled, taking account of the new regulatory rules for banks and the reduced availability of Canada Mortgage and Housing Corporation (CMHC)-related funding; and
* the liquidity auction format should be based on the "Product-Mix" design the United Kingdom uses for its Indexed Long-Term Repo, and until such time as a quantitative analysis on the effects of uniform versus discriminatory pricing is performed, the final sale price for term repos should continue to be based on a discriminatory pricing model, while term loan auctions should use uniform pricing.
EMERGENCY LIQUIDITY FACILITIES WORLDWIDE
In determining if the Bank of Canada should have permanent, predefined,...