22 Financial Policy Liquidity PDF

Central banking Normalization Global liquidity Challenges
Global Financial Systems

Chapter 22
Financial Policy: Part II, Central
bank and Liquidity
Jon Danielsson
London School of Economics
2015
To accompany
Global Financial Systems: Stability and Risk
http://www.globalfinancialsystems.org/
Published by Pearson 2013
Global Financial Systems 2015 Jon Danielsson, page 1 of 49
Book and slides
The tables and graphs are

the same as in the book
See the book for
references to original data
sources
Updated versions of the
slides can be downloaded
from the book web page
www.globalfinancialsystems.org

Version 3.2, November 2015

These slides draw on Chapter 22, Financial Policy: Part
II, Central bank and Liquidity that is published online

We dare not exercise our

independence for fear of losing
it
Arthur Burns, former Fed
Chairman

Changing role of central banking

Trend was generally towards purity only inflation
Financial stability, regulation in different bodies
The main tools: shortterm interest rates and CB
independence for credibility
CBs woefully unprepared when the crisis started in 2007
Lacking the necessary legal mandate, institutional
structure, expertise and desire to engage with the crisis
Now have enthusiastically embraced their new (old) roles
monetary policy
financial stability
supervision/regulation
fund governments

Politics and central banking
With monetary policy, only one measure (inflation) and

one main tool (interest rates)
This made life for central banks easy
MacroPru require many, often opaque, measures and a
complex set of tools
A wide variety of available tools may also create the
opportunity to politicize the process in selecting what
measure to adopt for a given scenario
Norway and LTV

Independence
Credibility is essential for monetary policy

Politicians will always be tempted to manipulate interest
rates
So hand the control of monetary policy to a credible and
politically independent central bank
Not possible for executing MacroPru
Control detailed behavior in a democratic society that
can only be done with the oversight of elected
representatives, i.e. politicians
Longterm danger is that reduced independence will
reduce credibility executing monetary policy

The central banker as superstar
The reputation of the senior staff essential for credibility

Central bankers should be staid judiciously avoiding
the limelight
If central bankers become too concerned with their public
persona, may act as a politician might
May then attract the wrong type of central banker
Danger of this now

Reputational risk
The failure to prevent a future banking crisis as

macroprudential regulator results in loss of confidence in
its ability to meet other objectives
Regulation is a tricky task and regulators can often get it
wrong
There is also no proof that central banks are better able
to act as regulator than an independent agency
BofE was stripped of its duty as regulator in the 1990s
after failures (BCCI)

Conflicting objectives
Financial stability and monetary policy may call for

opposite solutions
If inflationary pressures begin to arise while the financial
system is still fragile
Tough choices for the central bank
If it chooses to prioritize financial stability over monetary
policy, the central bank may lose its credibility as an
enforcer of price stability or vice versa

US monetary policy
normalization

The role of the US in global liquidity

expansion
The US dollar is the reserve currency

Learning from history: the FED injected liquidity to avoid
the recession experienced during the Great Depression
Other countries had little choice but to follow the US
monetary policy
So the US exported liquidity creation programs

The end of accommodative monetary policy
QE program was stopped in October 2014

US employment, inflation and growth have risen
So the FED should increase policy rates
But debates remain:
Has the US economy recovered enough?
What will be the impact on international markets
(particularly EMEs)?

Taper Tantrum - 2013
Bernanke announced the progressive interruption of the

QE program in May 2013 and a potential hike in policy
rates further ahead
Severe impacts on EMEs:
Capital outflows from bond markets
Increase in bond yield spreads
So rising rates could have severe impacts (short- and
long-term) on markets
But the US law only considers effects on the US, not
other countries!

Impact on global monetary policies
Normalization of US monetary policy will impact on other

countries
Which will have to react very quickly
How about the ECB and the BoE, which still conduct
wide liquidity injection programs?

Global liquidity

The role of liquidity
Liquidity is at the heart of almost every financial crisis

In upturns, virtuous circle between money flows,
investments, profits, leverage and mismatches
In downturns, things reverse even more rapidly, and the
bubble bursts
These chains of events can be referred to as global
liquidity phases
Most work on this issue has been done by the BIS

The first phase: 2000-2008

European banks in the first phase
European global
banks
shadow banking wholesale

system funding market
US banking
US borrowers US households
sector
US Border

Why did EU banks expand so rapidly?
The emergence of the euro

European banks were subject to Basel regulations earlier
than US banks
US banks were subject to the leverage ratio, while EU
banks were constrained by the RWA, which is more
amenable to this sort of transactions

Widespread availability of liquidity increased banking

sector inflows in many countries (including EU crisis
countries, Korea, Turkey).
The example of Spain:
In 1998, before joining the euro, total credit in Spain
reached e414 billion, entirely financed from Spanish
deposits
By 2008, total credit reached e2 trillion, with only half
being financed domestically

The second phase: 2009-2013

Financing from debt securities issuance
Retrenchment of major global banks (especially from the

EU) after the crisis
Borrowers in EMEs had easier access to international
capital markets
Local savers thought they could invest at home rather
than in US securities
In EMEs, particularly China and Brazil, the issuance of
debt securities in offshore financial centers plummeted

Outstanding international securities -

developing countries, all borrowers
2000 China nationality nationality

residence
1000
500
USD billion
200
100
50
20
10
5
1990 1995 2000 2005 2010 2015

Increase in international securities issuance

by EMEs corporates
Investors still want to avoid exposure to EMEs currencies

and legal systems
So EMEs corporate have issued more debt securities in
offshore financial centers
Where administrative, legal and tax costs are lower
Offshore markets are also more developed for
sub-investment grade bonds

Developing countries corporate issuance of

international securities
400 March 2007

March 2015
300
USD billion
200
100
0
China
Brazil
Russia
Korea
Mexico
UAB
India
Malaysia
Turkey
RSA
The third phase: 2013-...

Third phase: debt and liquidity

sustainability
Expansion of liquidity and debt has avoided to fall into a

global depression
Debt before 2007 was also unsustainably high
But the growth environment was much more positive
back then
Today there is slow growth and uncertainty regarding
world interest rates
Liquidity creation programs have created the illusion of
infinite liquidity

Third phase: three major concerns
First, offshore and foreign currency-denominated

securities have high currency risks;
Investors are not convinced about the strength of EMEs
economic fundamentals anymore
Second, FED rates hike may trigger a run on US dollar
assets and bring EME currencies downwards;
EME will be pushed to raise rates too, increasing EME
corporates debt burden
Third, maturity of EMEs overseas debt has increased,
which enhances duration and volatility risk for investors

Dangerous feedback loop
Tapering
yield
Asset curves
man- shift up FX
agers
run
corporate
Growth distress

Liquidity and debt: challenges

The liquidity and debt debate

have to, else depression depression when it ends
save the banking system encourages reckless behavior

from collapse moral hazard
without it economic activity excessive debt was the cause

would collapse of the crisis
creates jobs for the poor benefits the super wealthy
there is deflation inflation will happen

structural reforms too hard prevents structural reforms
fighting fire with fire hair of the dog
bad for savers lifeline for borrowers

Shift in the debate
Intitially, the argument for liquidity injection was to

prevent credit crunch
More recently it has been about supplying the economy

The only way to prevent depression and get

growth
Major concern is SMEs, which contribute importantly to

economic activity and jobs and are a strong political force
Liquidity was also injected so that the private financial
sector would intermediate the newly created liquidity to
important economic sector, especially SMEs.
Such arguments draw directly from the Great Depression
arguments

Saving the banks

Liquidity injection was also due to prevent bank failures
like after the Great Depression
The distinction between liquidity programs and bailouts is
fine
Liquidity injection aimed at banks is controversial: recall
moral hazard in the 2008 crisis
Banks operated under the assumption that they would be
bailed out anyways
On the other hand, bailout programs depend heavily on
the political support
But it is hard for political authorities to credibly commit
NOT to bail out
Income and wealth distribution
The liquidity policies postcrisis have changed the

composition of winners and losers
Biggest loosers are poorer savers, retirees and pensions
funds
Liquidity creation is supposed to affect income
distribution through three main channels
1. Income composition channel
2. Financial segmentation channel
3. Portfolio channel

Income composition channel
Households receive income from their work as well as

from business and financial incomes (when owning or
having shares in a company)
Accomodative monetary policy helps companies profits
directly but has a lower and indirect-only effect on wages
People who own companies are also usually wealthier

Financial segmentation channel
The financial sector is direct beneficiary from support

provided to financial markets
People employed in the financial sector already receive
high income and are wealthier
So increase in money supply resulting from
accommodative monetary policy widens the income
distribution gap

The portfolio channel
Wealthier households are those that own assets while

poorer households own less or are net debtors.
Any policy explicitly designed to support asset prices will
increase the wealth gap between the rich and the poor

Controlling inequalities is not the mere mandate of

central banks
But the FED and the BoE justified their QE program by a
trickle down argument: eventually, everybody should
benefit from liquidity creation
The BOE found that, in the UK, the benefits of QE were
heavily skewed towards the top 5% of households, who
own 40% of assets

Deflation: always bad?
Atkeson and Kehoe found no empirical link between

deflation and economic growth, except in the Great
Depression
Bordo and Filardo argue that there have been several
periods of good deflation
In late 1th 9 century, output rose by 2%3% a year in
times of deflation
Sweden and Switzerland have recently experienced
deflation yet were also among the fastest growing
economies in Europe

Longterm inflation
Post crisis liquidity creation programs would have been

highly inflationary if implemented before 2007
But the recent low inflation environment shows there are
still strong deflationary forces
Empirical research on interest rates suggests they are
mean reverting
Consider the example of the BoE, with an historical
average of 5.25%
The current near zero intrest rate is quite anomalous

Annual maximum bank rates, 2015 is to

November
15%
10%
5%
0%
1700 1750 1800 1850 1900 1950 2000
Fragilities
Recent monetary policies have made the private and

public sectors dependent on low interest rates
So it is harder to increase rates if and when inflation
increases
Example of the FED dilemma now

In the EU
If the European economies start picking up growth,

inflation is sure to follow
So it is very unlikely interest rates will remain so low
Unprofitable borrowers may get into serious difficulties
when interest rates rise
Today, banks are able to extend and pretend on a vast
amount of poorly collateralized real estate lending

Where has inflation gone?
Various QE programs have not lead to an increase in

inflation as expected
Most of all, banks have not been lending the freshly
created money, and kept it in their central bank reserve
accounts
While poor labor market conditions have prevented salary
growth

From self-reinforcing low interest rate

environment to high inflation environment
Prices and wages dont move
Expecting low inflation

Funding costs low
Funding costs rise
Expect inflation
Prices and wages increase

Market distortions and bubbles

Liquidity creation distorts markets
By encouraging risktaking that private entities do not
wish to take
Over time, divergence between Wall Street and Main
Street became bigger and bigger
Financial markets have become less likely to appropriately
react to good or bad economic news affecting the value
of an asset
Negative macroeconomic news in Europe in 2014 led to
a market rally rather than a drop
Deteriorating economic conditions increased the likelihood
of the ECB adopting QE

Structural reforms?
Undermines the support for necessary reforms

Shortterm benefits prevent longterm support for
reforms
Liquidity programs just kick the can down the road
Stronger economies may be able to delay adjustment
But EMEs may have a harder time reacting to liquidity
shocks

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Central banking Normalization Global liquidity Challenges

Global Financial Systems

Book and slides

The tables and graphs are

Global Financial Systems 2015 Jon Danielsson, page 2 of 49

Version 3.2, November 2015

Global Financial Systems 2015 Jon Danielsson, page 3 of 49

We dare not exercise our

Global Financial Systems 2015 Jon Danielsson, page 4 of 49

Changing role of central banking

Global Financial Systems 2015 Jon Danielsson, page 5 of 49

Politics and central banking

With monetary policy, only one measure (inflation) and

Global Financial Systems 2015 Jon Danielsson, page 6 of 49

Credibility is essential for monetary policy

Global Financial Systems 2015 Jon Danielsson, page 7 of 49

The central banker as superstar

The reputation of the senior staff essential for credibility

Global Financial Systems 2015 Jon Danielsson, page 8 of 49

The failure to prevent a future banking crisis as

Global Financial Systems 2015 Jon Danielsson, page 9 of 49

Financial stability and monetary policy may call for

Global Financial Systems 2015 Jon Danielsson, page 10 of 49

Global Financial Systems 2015 Jon Danielsson, page 11 of 49

The role of the US in global liquidity

The US dollar is the reserve currency

Global Financial Systems 2015 Jon Danielsson, page 12 of 49

The end of accommodative monetary policy

QE program was stopped in October 2014

Global Financial Systems 2015 Jon Danielsson, page 13 of 49

Taper Tantrum - 2013

Bernanke announced the progressive interruption of the

Global Financial Systems 2015 Jon Danielsson, page 14 of 49

Impact on global monetary policies

Normalization of US monetary policy will impact on other

Global Financial Systems 2015 Jon Danielsson, page 15 of 49

Global Financial Systems 2015 Jon Danielsson, page 16 of 49

The role of liquidity

Liquidity is at the heart of almost every financial crisis

Global Financial Systems 2015 Jon Danielsson, page 17 of 49

The first phase: 2000-2008

Global Financial Systems 2015 Jon Danielsson, page 18 of 49

European banks in the first phase

shadow banking wholesale

Global Financial Systems 2015 Jon Danielsson, page 19 of 49

Why did EU banks expand so rapidly?

The emergence of the euro

Global Financial Systems 2015 Jon Danielsson, page 20 of 49

Widespread availability of liquidity increased banking

Global Financial Systems 2015 Jon Danielsson, page 21 of 49

The second phase: 2009-2013

Global Financial Systems 2015 Jon Danielsson, page 22 of 49

Financing from debt securities issuance

Retrenchment of major global banks (especially from the

Global Financial Systems 2015 Jon Danielsson, page 23 of 49

Outstanding international securities -

2000 China nationality nationality

1990 1995 2000 2005 2010 2015

Global Financial Systems 2015 Jon Danielsson, page 24 of 49

Increase in international securities issuance

Investors still want to avoid exposure to EMEs currencies

Global Financial Systems 2015 Jon Danielsson, page 25 of 49

Developing countries corporate issuance of