Central Bank Archives

What Can Explain the Tale of Two FX Swap Rates in the Offshore Dollar Funding Market?

This Piece is part of the Stable Funding Series, by Elham Saeidinezhad

Mary Stigum once said, “Don’t fight the Fed!” There is perhaps no better advice that someone can give to an investor than to heed these words.

After the COVID-19 crisis, most aspects of the dollar funding market have shown some bizarre developments. In particular, the LIBOR-OIS spread, which used to be the primary measure of the cost of dollar funding globally, is losing its relevance. This spread has been sidelined by the strong bond between the rivals, namely CP/CD ratio and the FX swap basis. The problem is that such a switch, if proved to be premature, could create uncertainty, rather than stability, in the financial market. The COVID-19 crisis has already mystified the relationship between these two key dollar funding rates – CP/CD and FX swap basis- in at least two ways. First, even though they should logically track each other tightly according to the arbitrage conditions, they diverged markedly during the pandemic episode. Second, an unusual anomaly had emerged in the FX swap markets, when the market signaled a US dollar premium and discount simultaneously. For the scholars of Money View, these so-called anomalies are a legitimate child of the modern international monetary system where agents are disciplined, or rewarded, based on their position in the hierarchy. This hierarchy is created by the hand of God, aka the Fed, whose impact on nearly all financial assets and the money market, in particular, is so unmistakable. In this monetary system, a Darwinian inequality, which is determined by how close a country is to the sole issuer of the US dollar, the Fed, is an inherent quality of the system.

Most of these developments ultimately have their roots in dislocations in the banking system. At the heart of the issue is that a decade after the GFC, the private US Banks are still pulling back from supplying offshore dollar funding. Banks’ reluctance to lend has widened the LIBOR-OIS spread and made the Eurodollar market less attractive. Money market funds are filling the void and becoming the leading providers of dollar funding globally. Consequently, the CP/CD ratio, which measures the cost of borrowing from money market funds, has replaced a bank-centric, LIBOR-OIS spread and has become one of the primary indicators of offshore dollar funding costs.

The market for offshore dollar funding is also facing displacements on the demand side. International investors, including non-US banks, appear to utilize the FX swap market as the primary source of raising dollar funding. Traditionally, the bank-centric market for Eurodollar deposits was the one-stop-shop for these investors. Such a switch has made the FX swap basis, or “the basis,” another significant thermometer for calculating the cost of global dollar funding. This piece shows that this shift of reliance from banks to market-based finance to obtain dollar funding has created odd trends in the dollar funding costs.

Further, in the world of market-based finance, channeling dollars to non-banks is not straightforward as unlike banks, non-banks are not allowed to transact directly with the central bank. Even though the Fed started such a direct relationship through Money Market Mutual Fund Liquidity Facility or MMLF, the pandemic revealed that there are attendant difficulties, both in principle and in practice. Banks’ defiance to be stable providers of the dollar funding has created such irregularities in this market and difficulties for the central bankers.

The first peculiar trend in the global dollar funding is that the FX swap basis has continuously remained non-zero after the pandemic, defying the arbitrage condition. The FX swap basis is the difference between the dollar interest rate in the money market and the implied dollar interest rate from the FX swap market where someone borrows dollars by pledging another currency collateral. Arbitrage suggests that any differences between these two rates should be short-lived as there is always an arbitrageur, usually a carry trader, inclined to borrow from the market that offers a low rate and lend in the other market, where the rate is high. The carry trader will earn a nearly risk-free rate in the process. A negative (positive) basis means that borrowing dollars through FX swaps is more expensive (cheaper) than borrowing in the dollar money market.

Even so, the most significant irregularity in the FX swap markets had emerged when the market signaled a US dollar premium and a discount simultaneously. The key to deciphering this complexity is to carefully examine the two interest rates that anchor FX swap pricing. The first component of the FX swap basis reflects the cost of raising dollar funding directly from the banks. In the international monetary system, not all banks are created equal. For the US banks who have direct access to the Fed’s liquidity facilities and a few other high-powered non-US banks, whose national central banks have swap lines with the Fed, the borrowing cost is close to a risk-free interest rate (OIS). At the same time, other non-US banks who do not have any access to the central bank’s dollar liquidity facilities should borrow from the unsecured Eurodollar market, and pay a higher rate, called LIBOR.

As a result, for corporations that do not have credit lines with the banks that are at the top of the hierarchy, borrowing from the banking system might be more expensive than the FX swap market. For these countries, the US dollar trades at a discount in the FX swap market. Contrarily, when banks finance their dollar lending activities at a risk-free rate, the OIS rate, borrowing from banks might be less more expensive for the firms. In this case, the US dollar trades at a premium in the FX swap market. To sum up, how connected, or disconnected, a country’s banking system is to the sole issuer of the dollar, i.e., the Fed, partially determines whether the US dollar funding is cheaper in the money market or the FX swap market.

The other crucial interest rate that anchors FX swap pricing and is at the heart of this anomaly in the FX swap market is the “implied US dollar interest rate in the FX swap market.” This implied rate, as the name suggests, reflects the cost of obtaining dollar funding indirectly. In this case, the firms initially issue non-bank domestic money market instruments, such as commercial papers (CP) or certificates of deposits (CDs), to raise national currency and convert the proceeds to the US dollar. Commercial paper (CP) is a form of short-term unsecured debt commonly issued by banks and non-financial corporations and primarily held by prime money market funds (MMFs). Similarly, certificates of deposit (CDs) are unsecured debt instruments issued by banks and largely held by non-bank investors, including prime MMFs. Both instruments are important sources of funding for international firms, including non-US banks. The economic justification of this approach highly depends on the active presence of Money Market Funds (MMFs), and their ability and willingness, to purchase short-term money market instruments, such as CPs or CDs.

To elaborate on this point, let’s use an example. Let us assume that a Japanese firm wants to raise $750 million. The first strategy is to borrow dollars directly from a Japanese bank that has access to the global dollar funding market. Another competing strategy is to raise this money by issuing yen-denominated commercial paper, and then use those yens as collateral, and swap them for fixed-rate dollars of the same term. The latter approach is only economically viable if there are prime MMFs that are able and willing, to purchase that CP, or CD, that are issued by that firm, at a desirable rate. It also depends on FX swap dealers’ ability and willingness to use its balance sheet to find a party wanting to do the flip side of this swap. If for any reason these prime MMFs decide to withdraw from the CP or CD market, which has been the case after the COVID-19 crisis, then the cost of choosing this strategy to raise dollar funding is unequivocally high for this Japanese firm. This implies that the disruptions in the CP/CD markets, caused by the inability of the MMFs to be the major buyer in these markets, echo globally via the FX swap market.

On the other hand, if prime MMFs continue to supply liquidity by purchasing CPs, raising dollar funding indirectly via the FX swap market becomes an economically attractive solution for our Japanese firm. This is especially true when the regional banks cannot finance their offshore dollar lending activities at the OIS rate and ask for higher rates. In this case, rather than directly going to a bank, a borrower might raise national currency by issuing CP and swap the national currency into fixed-rate dollars in the FX swap market. Quite the contrary, if issuing short-term money market instruments in the domestic financial market is expensive, due to the withdrawal of MMFs from this market, for instance, the investors in that particular region might find the banking system the only viable option to obtain dollar funding even when the bank rates are high. For such countries, the high cost of bank-lending, and the shortage of bank-centric dollar funding, is an essential threat to the monetary stability of the firms, and the domestic monetary system as a whole.

After the COVID-19 crisis, it is like a tug of war emerged between OIS rates and the LIBORs as to which type of interest rate that anchor FX swap pricing. Following the pandemic, the LIBOR-OIS spread widened significantly and this war was intensified. Money View declares the winner, even before the war ends, to be the bankers, and non-bankers, who have direct, or at least secure path to the Fed’s balance sheet. Marcy Stigum, in her seminal book, made it clear not to fight the Fed and emphasized the powerful role of the Federal Reserve in the monetary system! Time and time again, investors have learned that it is fruitless to ignore the Fed’s powerful influence. Yet, some authors put little effort into trying to gain a better understanding of this powerful institution. They see the Fed as too complex, secretive, and mysterious to be readily understood. This list of scholars does not include Money View scholars. In the Money View framework, the US banks that have access to the Fed’s balance sheet are at the highest layer of the private banking hierarchy. Following them are a few non-US banks that have indirect access to the Fed’s swap lines through their national central bank. For the rest of the world, having access to the world reserve currency only depends on the mercy of the Gods.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

Is the Government’s Ambiguity about the Secondary Market a Terminal Design Flaw at the Heart of the PPP Loans?

The COVID-19 crisis has created numerous risks for small and medium enterprises (SMEs). The only certainty for SMEs has been that the government’s support has been too flawed to mitigate the shock. The program’s crash is not an accident. As mentioned in the previous Money View blog, one of the PPP loan design flaws is the government’s reliance on banks to act traditionally and intermediate credit to SMEs. Another essential, yet not well-understood design flaw at the heart of the PPP loan program is its ambiguity about the secondary market. The structure I propose to resolve such uncertainty focuses on the explicit government guarantee for the securitization of the PPP loans, similar to the GSE’s role in the mortgage finance system.

Such flaws are the byproduct of the central bank’s tendency to isolate shadow banking, and its related activities, from traditional banking. These kinds of bias would not exist in the “Money View” framework, where shadow banking is a function rather than an entity. “Money market funding of capital market lending” is a business deal that can happen in the balance sheet of any entity- including banks and central banks. One way to identify a shadow banker from a traditional banker is to focus on their sources and uses of finance. A traditional banker is simply a credit intermediary. Her alchemy is to facilitate economic growth by bridging any potential mismatch between the kind of liabilities that borrowers want to issue (use of finance) and the nature of assets that creditors want to hold (source of funding). Nowadays, the mismatch between the preferences of borrowers and the preferences of lenders is increasingly resolved by “price changes” in the capital market, where securities are traded, rather than by traditional intermediation. Further, banks are reluctant to act as a financial intermediary for retail depositors as they have already switched to their more lucrative role as money market dealers.

Modern finance emphasizes that no risk is eliminated in the process of “credit intermediation,” only transferred, and sometimes quite opaquely. Such a conviction gave birth to the rise of market-based finance. In this world, a shadow banker, sometimes a bank, uses its source of funding, usually overnight loans, to supply “term-funding” in the wholesale money market. In doing so, it acts as a dealer in the wholesale money market. Also, financial engineering techniques, such as securitization, by splitting the securitized assets into different tranches, allows a shadow banker to “enhance credit ” while transferring risks to those who can shoulder them. The magic of securitization enables a shadow banker to tap capital-market credit in the secondary market. Ignoring the secondary market is a fatal problem in the design of PPP loans.

To understand the government pandemic stimulus program for the SMEs, let’s start by understanding the PPP loan structure. The U.S. Treasury, along with financial regulators such as the Fed, adopted two measures to facilitate aid to SMEs under the CARES Act. First, the Fed announced the formation of the Paycheck Protection Program Loan Facility (the “PPPLF”). This program enables insured depository institutions to obtain financing from the Fed collateralized by Paycheck Protection Program (“PPP”) loans. The point to emphasize here is that the Fed, in essence, is the ultimate financier of such loans as banks could use the credits to SMEs as collateral to finance their lending from the Fed. Second, PPP loans are assigned a zero-percent risk-weight for purposes of U.S. risk-based capital requirements. This feature is essentially making PPP loans exempt from risk-based (but not leverage) capital requirements when held by a banking organization subject to U.S. capital requirements.

Despite the promising appearance of such programs, the money is not flowing towards SMEs. One of the deadly flaws of this program is that it overlooks the importance of the secondary market. Specifically, ambiguity exists regarding the Small Business Administration (SBA)’s role in the secondary market due to the nature of the PPP loans and how they are regulated. The CARES Act provides that PPP loans are a traditional form of the SBA guaranteed loan. Such a statement implies that the PPP loans would not be 100% guaranteed in the secondary market as the SBA guaranteed loans are subject to certain conditions that should be satisfied by the borrower. First, the SBA wants to ensure that the entity claiming a right to payment from the SBA holds a valid title to the SBA loan. Second, the SBA requires the borrower to fulfill the PPP’s forgiveness requirements. Securitization requires the consent of the SBA. What is not mentioned in the CARES Act is that the SBA’s existing regulations restrict the ability of such loans to be transferred in the secondary market. Such restrictions block the credit to flow to the SMEs.

Under such circumstances, free transfer of PPPs in the secondary market could result in chaos when the PPP loans are later presented to the SBA by the holder for forgiveness or guarantee. Some might propose to ask for approval from the SBA before the securitization process. Yet, prior approval requirements for loan transfers, even though it might reduce the confusion mentioned above, hinder the ability to transfer newly originated PPP loans into the secondary market. Given that the PPP entails a massive amount of loans – $349 billion – to be originated in a short period, transfer restrictions could have a material impact on the ability to get much-needed funding to small businesses quickly. The program’s failure to notice such a conflict is a byproduct of the government’s tendency to ignore the role of the secondary market in the success of programs that aims at providing credit to retail depositors.

A potential solution would be for a government agency, such as the Small Business Administration (SBA), to guarantee the PPP loans in the secondary market in the same manner as Fannie Mae and Freddie Mac do for the mortgage loans. Fannie Mae and Freddie Mac are government-sponsored enterprises (the GSEs) that purchase mortgages from banks and use securitization to enhance the flow of credit in the mortgage market. The GSEs help the flow of credit as they have a de facto subsidy from the government. The market believes that the government will step in to guarantee their debt if they become insolvent. For the case of the PPP loans, instead of banks keeping the loans on their balance sheet until the loan was repaid, the bank who made the loan to the SMEs (the originator) should be able to sell the loan to the SBA. The SBA then would package the PPP loans and sells the payment rights to investors. The point to emphasize here is that the government both finance such loans in the primary market- the Fed accepts the PPP loans as collateral from banks- and ensures the flow of credit by securitizing them in the secondary market. Such a mechanism provides an unambiguous and ultimate guarantee for the PPP loans in the credit market that the government aims at offering anyways. This kind of explicit government guarantee could also help the smooth flow of credit to SMEs, which has been the original goal of the government in the first place.

Money View, through its recognition of banks as money market dealers in market-based finance and originators of securitized assets, could shed some light on the origins of those complications. Previously in the Money View blog, I proposed a potential solution to circumvent banks and directly injecting credit to the SMEs, through tools such as central bank digital currencies (CBDC). In this piece, the proposal is to adopt the design of the mortgage finance system to provide unambiguous government support and resolve the perplexities regarding marketing PPP loans in the secondary market. Until this confusion is resolved, banking entities with regulatory or internal funding constraints may be unwilling to originate PPP loans without a clear path for obtaining financing or otherwise transferring such credits into the secondary market. Such failures come at the expense of retail depositors, including small businesses.

Acknowledgment: Writing this piece would not be possible without a fruitful exchange that I had with Dr. Rafael Lima Sakr, a Teaching Fellow at Edinburgh Law School.

In a World Where Banks Do Not Aspire to be Intermediaries, Is It Time to Cut Out the Middlemen? (Part I)

“Bankers have an image problem.”
Marcy Stigum

By Elham Saeidinezhad | Despite the extraordinary quick and far-reaching responses by the Fed and US Treasury, to save the economy following the crisis, the market sentiment is that “Money isn’t flowing yet.” Banks, considered as intermediaries between the government and troubled firms, have been told to use the liberated funds to boost financing for individuals and businesses in need. However, large banks are reluctant, and to a lesser extent unable, to make new loans even though regulators have relaxed capital rules imposed in the wake of the last crisis. This paradox highlights a reality that has already been emphasized by Mehrling and Stigum but erred in the economic orthodoxy.

To understand this reluctance by the banks, we must preface with a careful look at banking. In the modern financial system, banks are “dealers” or “market makers” in the money market rather than intermediaries between deficit and surplus agents. In many markets such as the UK and US, these government support programs are built based on the belief that banks are both willing and able to switch to their traditional role of being financial intermediaries seamlessly. This intermediation function enables banks to become instruments of state aid, distributing free or cheap lending to businesses that need it, underpinned by government guarantees. This piece (Part l) uses the Money View and a historical lens to explain why banks are not inspired anymore to be financial intermediaries. In Part ll, we are going to propose a possible resolution to this perplexity. In a financial structure where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most.

Stigum once observed that bankers have, at times, an image problem. They are seen as the culprits behind the high-interest rates that borrowers must pay and as acting in ways that could put the financial system and the economy at risk, perhaps by lending to risky borrowers, when interest rates are low. Both charges reflect the constant evolution in banks’ business models that lead to a few severe misconceptions over the years. The first delusion is about the banks’ primary function. Despite the common belief, banks are not intermediaries between surplus and deficit agents anymore. In this new system, banks’ primary role is to act as dealers in money market securities, in governments, in municipal securities, and various derivative products. Further, several large banks have extensive operations for clearing money market trades for nonbank dealers. A final important activity for money center banks is foreign operations of two sorts: participating in the broad international capital market known as the Euromarket and operating within the confines of foreign capital markets (accepting deposits and making loans denominated in local currencies).

Structural changes that have taken place on corporates’ capital structure and the emergence of market-based finance have led to this reconstruction in the banking system. To begin with, the corporate treasurers switched sources of corporate financing for many corporates from a bank loan to money market instruments such as commercial papers. In the late 1970s and early 1980s, when rates were high, and quality-yield spreads were consequently wide, firms needing working capital began to use the sale of open market commercial paper as a substitute for bank loans. Once firms that had previously borrowed at banks short term were introduced to the paper market, they found that most of the time, it paid them to borrow there. This was the case since money obtained in the credit market was cheaper than bank loans except when the short-term interest rate was being held by political pressure, or due to a crisis, at an artificially low level.

The other significant change in market structure was the rise of “money market mutual funds.” These funds provide more lucrative investment opportunities for depositors, especially for institutional investors, compared to what bank deposits tend to offer. This loss of large deposits led bank holding companies to also borrow in the commercial paper market to fund bank operations. The death of the deposits and the commercial loans made the traditional lending business for the banks less attractive. The lower returns caused the advent of the securitization market and the “pooling” of assets, such as mortgages and other consumer loans. Banks gradually shifted their business model from a traditional “original and hold” to an “originate-to-distribute” in which banks and other lenders could originate loans and quickly sell them into securitization pools. The goal was to increase the return of making new loans, such as mortgages, to their clients and became the originators of securitized assets.

The critical aspect of these developments is that they are mainly off-balance sheet profit centers. In August 1970, the Fed ruled that funds channeled to a member bank that was raised through the sale of commercial paper by the bank’s holding company or any of its affiliates or subsidiaries were subject to a reserve requirement. This ruling eliminated the sale of bank holding company paper for such purposes. Today, bank holding companies, which are active issuers of commercial paper, use the money obtained from the sale of such paper to fund off-balance sheet, nonbank, activities. Off-balance sheet operations do not require substantial funding from the bank when the contracts are initiated, while traditional activities such as lending must be fully funded. Further, most of the financing of traditional activities happens through a stable base of money, such as bank capital and deposits. Yet, borrowing is the primary source of funding off-balance sheet activities.

To be relevant in the new market-based credit system, and compensate for the loss of their traditional business lines, the banks started to change their main role from being financial intermediaries to becoming dealers in money market instruments and originators of securitized assets. In doing so, instead of making commercial loans, they provide liquidity backup facilities on commercial paper issuance. Also, to enhance the profitability of making consumer loans, such as mortgages, banks have turned to securitization business and have became the originators of securitized loans.

In the aftermath of the COVID-19 outbreak, the Fed, along with US Treasury, has provided numerous liquidity facilities to help illiquid small and medium enterprises. These programs are designed to channel funds to every corner of the economy through banks. For such a rescue package to become successful, these banks have to resume their traditional financial intermediary role to transfer funds from the government (the surplus agents) to SMEs (the deficit agents) who need cash for payroll financing. Regulators, in return, allow banks to enjoy lower capital requirements and looser risk-management standards. On the surface, this sounds like a deal made in heaven.

In reality, however, even though banks have received regulatory leniency, and extra funds, for their critical role as intermediaries in this rescue package, they give the government the cold shoulder. Banks are very reluctant to extend new credits and approve new loans. It is easy to portray banks as villains. However, a more productive task would be to understand the underlying reasons behind banks’ unwillingness. The problem is that despite what the Fed and the Treasury seem to assume, banks are no longer in the business of providing “direct” liquidity to financial and non-financial institutions. The era of engaging in traditional banking operations, such as accepting deposits and lending, has ended. Instead, they provide indirect finance through their role as money market dealers and originators of securitized assets.

In this dealer-centric, wholesale, world, banks are nobody’s agents but profits’. Being a dealer and earning a spread as a dealer is a much more profitable business. More importantly, even though banks might not face regulatory scrutiny if these loans end up being nonperforming, making such loans will take their balance sheet space, which is already a scarce commodity for these banks. Such factors imply that in this brave new world, the opportunity cost of being the agent of good is high. Banks would have to give up on some of their lucrative dealing businesses as such operation requires balance sheet space. This is the reason why financial atheists have already started to warn that banks should not be shamed into a do-gooder lending binge.

Large banks rejected the notion that they should use their freed-up equity capital as a basis for higher leverage, borrowing $5tn of funds to spray at the economy and keep the flames of coronavirus at bay. Stigum once said that bankers have an image problem. Having an image problem does not seem to be one of the banks’ issues anymore. The COVID-19 crisis made it very clear that banks are very comfortable with their lucrative roles as dealers in the money market and originators of assets in the capital market and have no intention to be do-gooders as financial intermediaries. These developments could suggest that it is time to cut out banks as middlemen. To this end, central bank digital currency (CBDC) could be a potential solution as it allows central banks to bypass banks to inject liquidity into the system during a period of heightened financial distress such as the COVID-19 crisis.

Is our Monetary System as Systemic and International as Coronavirus?

By Elham Saeidinezhad | The coronavirus crisis has sparked different policy responses from different countries. The common thread among these reactions is that states are putting globalization on pause. Yet, re-establishment of central bank swap lines is making “money,” chiefly Eurodollars, the first element that has become more global in the wake of the Coronavirus outbreak. This is not an unexpected phenomenon for those of us who are armed with insights from the Perry Mehrling’s “Money View” framework. The fact that the monetary system is inherently international explains why the Fed reinstalled its standing U.S. dollar liquidity swap line arrangements with five other central banks just after it lowered its domestic federal fund’s target to zero percent. However, the crisis also forces us to see global dollar funding from a lens closer to home; the fact that the Eurodollar market, at its core, is a domestic macro-financial linkage. In other words, its breakdown is a source of systemic risk within communities as it disrupts the two-way connection between the real economy and the financial sector. This perspective clarifies the Fed’s reactions to the crisis in hand. It also helps us understand the recent debate in the economics profession about the future of central bank tools.

The Great Financial Crisis of 2008-09 confirmed the vital importance of advancing our understanding of macro-financial linkages. The Coronavirus crisis is testing this understanding on a global scale. Most of the literature highlights the impact of sharp fluctuations in long-term fundamentals such as asset prices and capital flows on the financial positions of firms and the economy. In doing so, economists underestimate the effects of disturbances in the Eurodollar market, which provides short-term dollar funding globally, on real economic activities such as trade. These miscalculations, which flow from economists’ natural approach to money as a veil over the real economy, could be costly. Foreign banks play a significant role in the wholesale Eurodollar market to raise US dollar financing for their clients. These clients, usually multinational corporations, are part of a global supply chain that covers different activities from receiving an order to producing the final goods and services. Depending on their financial positions, these firms either wish to hold large dollar balances or receive dollar–denominated loans. The deficit firms use the dollar funding to make payments for their purchases. The surplus firms, on the other hand, expect to receive payments in the dollar after selling their products. The interconnectedness between the payment system and global supply chains causes the Eurodollar market to act as a bridge between the real economy and the financial sector.

The Coronavirus outbreak is putting a strain on this link, both domestically and globally: it disrupts the supply chain and forces every firm along the chain to become a deficit agent in the process. The supply chain moves products or services from one supplier to another and is essentially the sum of all firms’ sales. These sales (revenues) are, in effect, a measure of payments, the majority of which occur in the Eurodollar market. A sharp shock to the sale, as a result of the outbreak, precipitates a lower ability to make payments. When an output is not being shipped, the producer of final goods in China does not have dollar funding to pay the suppliers of intermediate products. As a result, firms in other countries do not have a dollar either. The trauma that coronavirus crisis injects into manufacturing and other industries thus leads to missed payments internationally. Missed payments will make more firms become deficit agents. This includes banks, which are lower down in the hierarchy, and the central banks, which are responsible for relaxing the survival constraints for the banking system. By focusing on the payments system and Eurodollar market, we were able to see the “survival constraint” in action.

The question for monetary policy is how far the central bank decides to relax that survival constraint by lowering the bank rate. This is why central banks, including the Fed, are reducing interest rates to zero percent. However, the ability to relax the survival constraint for banks further down in the hierarchy depends also on the strength of foreign central banks to inject dollar funding into their financial system. The Fed has therefore re-established the dollar swap line with five other major central banks. The swap lines are available standing facilities and serve as a vital liquidity backstop to ease strains in global funding markets. The point to hold on to here is that the U.S. central bank is at a level in the hierarchy above other central banks

Central banks’ main concern is about missed payments of U.S. dollars, as they can deal with missed payments in local currency efficiently. In normal circumstances, the fact that non-U.S. central banks hold foreign exchange reserves enables them to intervene in the market seamlessly if private FX dealers are unable to do so. In these periods, customer-led demand causes some banks to have a natural surplus position (more dollar deposits than loans) and other banks to have an inherent deficit position (more dollar loans than deposits). FX dealers connect the deficit banks with the surplus banks by absorbing the imbalances into their balance sheets. Financial globalization has enabled each FX dealer to resolve the imbalance by doing business with some U.S. banks, but it seems more natural all around for them to do business with each other. During this crisis, however, even U.S. banks have started to feel the liquidity crunch due to the negative impacts of the outbreak on financial conditions. When U.S. banks pull back from market-making in the Eurodollar market, there will be a shortage of dollar funding globally. Traditionally, in these circumstances, foreign central banks assume the role of the lender of last resort to lend dollars to both banks and non-banks in their jurisdiction. However, the severity of the Coronavirus crisis is creating a growing risk that such intermediation will fracture. This is the case as speculators and investors alike have become uncertain of the size of foreign central banks’ dollar reserve holding.

To address these concerns, the Fed has re-established swap lines to lend dollars to other central banks, which then lend it to banks. The swap lines were originally designed to help the funding needs of banks during 2008. However, these swap lines might be inadequate to ease the tension in the market. The problem is that the geographic reach of the swap lines is too narrow. The Fed has swap lines only with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. The reason is that the 2008-09 financial crisis affected banks in these particular jurisdictions severely. But the breadth of the current crisis is more extensive as every country along the supply chain is struggling to get dollars. In other words, the Fed’s dollar swap lines should become more global, and the international hierarchy needs to flatten.

To ease the pressure of missed payments internationally, and prevent the systemic risk outbreak domestically, the Fed and its five major central bank partners have coordinated action to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements. These tools help to mitigate the effects of strains on the supply chain, both domestically and abroad. Such temporary agreements have been part of central banks’ set of monetary policy instruments for decades. The main lessons from the Coronavirus outbreak for central bank watchers is that swap lines and central bank collaborations, are here to stay — indeed, they should become more expansive than before. These operations are becoming a permanent tool of monetary policy as financial stability becomes a more natural mandate of the central banks. As Zoltan Pozsar has recently shown, the supply chain of goods and services is the reverse of the dollar funding payment system. Central banks’ collaboration prevents this hybridity from becoming a source of systemic risk, both domestically and internationally.

This piece was originally part of “Special Edition Roundtable: Money in the Time of Coronavirus” by JustMoney.org platform.

Central Banks and the Folk Tales of Money

By Pierre Ortlieb.

On June 10th, 2018, Swiss voters participated in a referendum on the very nature of money creation in their small alpine republic. The so-called “Vollgeld Initiative,” or “sovereign money initiative,” on their ballots would have required Swiss commercial banks to fully back their “demand deposits” in central bank money, effectively stripping private banks of their power to create money through loans in the current fractional reserve banking system.

In the build-up to this poll, the Swiss National Bank (SNB) tailored their statements on credit creation based on their audience: when speaking to the public, the SNB chose to promulgate an outdated “loanable funds” model of money creation, while it adopted an endogenous theory of credit creation when speaking to market participants. This served to mollify both audiences, reassuring them of the ability and sophistication of the SNB. Yet the contradicting stories offered by the SNB are part of a broader trend that has emerged as central banks have expended tremendous effort on trying to communicate their operations, with different banks offering different explanations for how money is
created. This risks damaging public trust in money far more than any referendum could.

***

At the SNB annual General Shareholders Meeting in April 2018, Governor Thomas Jordan was verbally confronted by two members of the audience who demanded Jordan explain how money is created – Jordan’s understanding of credit, they argued, was flawed and antiquated. Faced with this line of questioning, Jordan rebutted that banks use sight deposits from other customers to create loans and credit. The audience members pushed back in disagreement, but Jordan did not waver.

On the surface, Jordan’s claim on money creation is an explanation one would find in most economics textbooks. In this common story, banks act as mere intermediaries in a credit creation process that transforms savings into productive investment.

However, only months earlier, Governor Jordan told a different story in a speech delivered to the Zürich Macroeconomics Association. Facing an audience of economists and market professionals, Jordan had embraced a portrayal of money creation that is more modern but starkly opposed to the more folk-theoretical, or “textbook” view. Jordan described how “deposits at commercial banks” are created: In the present-day financial system, when a bank creates a loan, “an individual bank increases deposits in the banking system and hence also the overall money supply.” This is the antithesis of the folk theory offered to the public, presenting a glaring contradiction. Yet the SNB’s duplicity is part of a broader trend: central banks are unable to provide a unified message on credit creation, both internally and among themselves.

For instance, in 2014, the Bank of England published a short, plainly-written paper that described in detail how commercial banks create money essentially out of nothing, by issuing loans to their customers. The Bank author’s noted that “the reality of how money is created today differs from the description found in some economics textbooks,” and sought to correct what they perceived as a popular misinterpretation of the credit creation process. Norges Bank, Norway’s monetary authority, has made a similar push to clarify that credit creation is driven by commercial banks, rather than by printing presses in the basement of the central bank. Nonetheless, other central banks, such as the Bundesbank, have gone to great lengths to stress that monetary authorities have strict control the money supply. As economist Rüdiger Dornbusch notes, the German saving public “have been brought up to trust in the simple quantity theory” of money, “and they are not ready to believe in a new institution and new operating instructions.”

***

While this debate over the mechanics of money creation may seem arcane, it has crucial implication for central bank legitimacy. During normal times, trust in money is built through commonplace uses of money; money works best when it can be taken for granted. As the sociologist Benjamin Braun notes, a central bank’s legitimacy depends in part on it acting in line with a dominant, textbook theory of money that is familiar to its constituents.

Yet this is no longer the case. Since the financial crisis, this trust has been shaken, as exemplified by Switzerland’s referendum on sovereign money in June 2018. Faced with political pressures and uncertain macroeconomic environments, some central banks have had to be much more proactive about their communications, and much more frank about the murky nature of money. As quantitative easing has stoked public fears of price instability, monetary authorities including the Bank of England have sought to clarify who really produces money. In this sense, taking steps to inform the public on the real source of money – bank loans – is a worthwhile step, as it provides constraints on what a central bank can be reasonably expected to do, and reduces informational asymmetries between technical experts and lay citizens.

On the other hand, a number of central banks have taken the dangerous approach of simply tailoring their message based on their audience: when speaking to technical experts, say one thing, and when speaking to the public, say another. The janus-faced SNB is a case in point. This rhetorical duplicity is important as it allows central banks to both assuage popular concerns over the stability of money, by fostering the illusion that they maintain control over price stability and monetary conditions, while similarly soothing markets with the impression that they possess a nuanced and empirically accurate framework of how credit creation works. For both audiences, this produces a sense of institutional commitment which sustains both public and market trust in money under conditions of uncertainty.

Yet this newfound duplicity in central bank communications is perilous, and risks further undermining public trust in money should they not succeed in straddling this fine line. Continuing to play into folk theories of money as these drift further and further away from the reality of credit creation will inevitably have unsettling ramifications. For example, it might lead to the election of politicians keen to exploit and pressure central banks, or the production of crises in the form of bank runs.

Germany’s far-right Alternative für Deutschland, for instance, was founded and achieved its initial popularity as a party opposed to the allegedly inflationary policies of the European Central Bank, which failed to adequately communicate the purpose of its expansionary post-crisis monetary program. Once a central bank’s strategies and the public’s understanding of money become discordant, they lose the ability to assure their constituents of the continued functioning of money, placing their own standing at risk.

Central banks would be better off engaging in a clear, concise, and careful communications program to inform the public of how credit actually works, even if they might not really want to know how the sausage gets made. Otherwise, they risk further shaking public trust in critical monetary institutions.

About the Author: Pierre Ortlieb is a graduate student, writer, and researcher based in London. He is interested in political economy and central banks, and currently works at a public investment think tank (the views expressed herein do not represent those of his employer).

Victorian despite themselves: central banks in historical perspective

Central banks have not always been independent, inflation targeting bodies, and to treat them as such is to obscure their complex histories and alternative institutional constellations

Central banks have not always been independent, inflation targeting bodies, and to treat them as such is to obscure their complex histories and alternative institutional constellations. By Pierre Ortlieb.

Donald Trump’s most recent feud with the Federal Reserve reached a new peak late last week as the U.S. President lambasted the institution’s policy stance. “I don’t have an accommodating Fed,” he noted. Commentary on Trump’s outburst is perhaps even more alarming than his words themselves. For instance, The Week noted that Trump’s encroachment on Fed independence was “essentially unprecedented”; imperiling the central bank’s status as a guardian of price stability was reckless, foolish. This reading of the history of central banks is misguided, however. Our current paradigm of independent central banks deploying their tools to maintain low inflation is a deeply contingent historical phenomenon and obscures central banks’ frequent role as publicly-controlled institutions and fiscal buttresses throughout their centuries of existence.

The contemporary notion of independent, conservative central banks was enshrined gradually over the 1990s, a decade in which over thirty countries – developed and developing – guaranteed the legal and operational independence of their monetary authorities. This institutionalization of inflation-averse central banks has come hand-in-hand with an aversion to “inflationary” deficit financing and fiscal expansionism, which has been restrained by an exclusive focus on price stability. This has come to be treated as the best practice approach to central banking, a paradigm which, until recently, was rarely questioned among policymakers. Reaction to Donald Trump’s comments has been emblematic of this.

Yet the history of central banks shows them to be far more intertwined with states and treasuries than current commentary or policy would suggest. At their founding, central banks frequently served not as constraints on the state, but rather as fiscal agents of the state. The inception of the Bank of England (BoE) in 1694, for example, was the result of a compromise that granted the state loans to finance its war with France, while the BoE was granted the right to issue and manage banknotes. As a result of this bargain, the market for public debt in the United Kingdom exploded in the 18th century, and government debt peaked at 260 percent of GDP during the Napoleonic wars. This both facilitated the expansion of Britain’s hegemonic financial position and enabled the industrial revolution, as borrowing at low risk made vast industrial development possible.

Direct state financing was, however, not the only means through central banks fostered favorable monetary conditions and growth during this era. The use of various “gold devices” to manage credit conditions from within the straitjacket of the gold standard was commonplace. The Reichsbank, for example, granted interest-free loans to importers of gold and inhibited gold exports to establish de facto exchange controls and some degree of exchange rate flexibility.

Various central banks also pursued sectoral policies, lending government-subsidized credit at lower real interest rates to key developmental industries. The 1913 Federal Reserve Act, for instance, was designed such that it would improve the global competitiveness of New York financial institutions. It is important to note that at the time, these central banks were largely established as private institutions with government-backed monopolies; yet this did not alter the fact that, in practice, they served as crucial instruments for the expansion and development of Western economies. Beyond the US and the UK, central banks across Western Europe, such as the Banque de France (1800), the Bank of Spain (1874), and the Reichsbank (1876), served a similar initial function as developmental agents of their respective states.

Nevertheless, this was not a uniform or constant system. The existence of the gold standard itself constrained the use of monetary instruments to foster growth across developed economies during the late 19th century. Furthermore, Victorian-era British policy came to revolve around sound finance and fiscal discipline, as the use of a central bank to finance the national state was increasingly in tension with Britain’s central position in the international trading system. Inflationary fiscal deficits were seen as inhibiting growth and dampening international investment. This “Victorian model” focus on price stability produced a paradigm shift in the UK away from expansionary deficit financing towards more restrained policy.

Despite interludes, the use of central banks as macroeconomic instruments endured and emerged reinforced in the aftermath of the Great Depression and the Second World War. After 1945, governments across the Western world adopted full employment objectives as part of the consensus of “embedded liberalism,” a practice which often also involved nationalizing central banks, so they could serve as tools of macroeconomic policy. Credit allocation came to serve social goals, and central banks were given additional tasks such as managing capital flows to maintain low interest rates. In France, the Banque de France was brought under the umbrella of the National Credit Council, the institution charged with managing financial aspects of government industrial and modernization policies. While other countries employed different mechanisms in implementing this consensus, the overarching aim of monetary institutions serving social goals was broadly shared across developed countries in the postwar era, as it had been during the 19th century during the infancy of central banks.

This consensus of central banks undergirding fiscal policy fragmented and fell apart from the 1970s onwards. The experience of stagflation, the increasing influence of financial institutions in policymaking, as well as a growing academic consensus on the dangers of central bank collusion with governments, dismantled both the expansionary fiscal state and the subservient central bank. The “Volcker revolution” in the United States was a first step in the gradual, post-Nixon institutionalization of a price stability-focused, independent central bank. The Bank of England was granted operational independence in 1997 by Labour Chancellor Gordon Brown, while the ECB has been independent since its inception in 1998.

The current paradigm of independent, inflation targeting central banks thus obscures the messy history of central banks as public institutions. Since their inception, monetary authorities have performed various different roles; while they served as guardians of price stability in Victorian England, they have originally served as developmental and fiscal agents for expansionary states, and have frequently continued to do so in the centuries since. Treating central bank independence as an ahistorical best practice approach is misleading, and we should recall that there have been alternatives to the current framework. As some have heralded the end of the era of central bank independence, while others have underscored the benefits of re-politicizing monetary policy, it is worth bearing this history in mind.