Central Bank as the “Market-Maker of the Last Resort”

In my blog last week titled “Jusen,” I described how the financial regulators in Japan delayed the process of cleaning up the housing loan companies (jusen) after the fall of land prices (early 1990s) and ended up worsening the problem. I appreciate the comments, which I find right on the mark and prompted me to write this blog. The title comes from a phrase in London Banker’s comment, which seems very apt in describing the expanding role of the Federal Reserve Bank and other central banks.

Many commentators argued that the Federal Reserve Bank’s (and the Bank of England’s) provision of credit to banks with sometimes questionable collateral (mortgage, for example) may play the same role as a “rescue fund.” This is a legitimate concern and an important one.

Such an action by the central bank may allow banks to postpone full resolution of losses they incurred, which will further increase the eventual cost of resolution. If such assistance from the central banks is somehow designed to encourage the banks to clean up the SIVs and other problem assets once and for all, however, that could be a useful part of the policy package. The general principle here is indeed the same as the one that Nouriel Roubini argues in his March 19th blog “The Worst Financial Crisis Since the Great Depression is Getting Worse…and the Need for Radical Policy Solutions to the Crisis” on government intervention in mortgage contacts. The government intervention should “not be aimed to prevent the necessary adjustment of asset prices.” It should be “aimed at ensuring that the necessary adjustment is not disorderly.” The same can be said for the central bank intervention.

The issue for the central bank, however, is further complicated by the fact that the central bank is responsible for monetary policy as well. Sometimes the goal of maintaining price stability may contradict prudential regulation of financial institutions. This is a general problem when the central bank is both monetary authority and financial regulator, as it is the case for the Federal Reserve System. If the central bank puts too much weight on its role as a financial regulator, the central bank may have an incentive to loosen the monetary policy too much to avoid financial instability. If the central bank is primarily concerned with price stability, it may end up assisting the financial institutions too much to be consistent with prudential regulation.

Japanese case in the late 1990s to the early 2000s provides us with an interesting example in considering the relation between bank regulation and monetary policy. The Bank of Japan was not a primary bank regulator in Japan, but it emphasized the importance for Japanese banks to resolve their non-performing loans. The BOJ stressed the importance of restructuring banking sector so much that it held monetary policy too tight (even though their monetary policy was extremely loose by conventional measure with overnight interbank rate at zero percent). For example, the BOJ (temporarily it turned out) stopped the zero interest policy in August 2000 when the inflation rate was still negative. They were also reluctant in trying non-traditional monetary expansion (such as buying up non-performing loans) that many foreign observers advocated back then.

When the BOJ started the zero interest rate policy in 1999, the BOJ already believed that restructuring of banking sector is at least as important as the monetary expansion. So the BOJ announced:

In order to bring Japanese economy back to a solid recovery path, it is important not only to provide support from monetary and fiscal sides but also to steadily promote financial system revitalization and structural reforms. (“Change of the Guideline for Money Market Operations,” February 12, 1999.)

The restructuring of the Japanese banks, however, did not proceed as quickly as the BOJ hoped. The BOJ’s suspension of the zero interest rate policy in August 2000 can be even seen as a result of its frustration on the slow progress of banking reform and its attempt to force the restructuring. The following announcement, which was issued right before the BOJ started the “quantitative easing,” shows that the BOJ was still frustrated and believed that the resolution of non-performing loans and other structural reform is more important than the monetary expansion.

To realize the full permeation of the effects of strong monetary easing, it is essential to strengthen a financial system and ensure its stability by making a swift move to resolve the non-performing loan problem. It is also vital to make progress in structural reform on the economic and industrial fronts through tax reform, streamlining of public financial institutions, and deregulation. The Bank strongly hopes that both the Government and the private sector, in particular financial institutions, will take more determined and effective steps in this regard. (“On Today’s Decision at the Monetary Policy Meeting,” February 28, 2002)

Thus, the experience of the BOJ suggests that the concern for prudential regulation may have discouraged the central bank from experimenting with non-traditional monetary expansion. The current situation in the U.S. is very different. At the positive (and maybe increasing) inflation rate, the real federal funds rate is probably already negative. So, the potential problem is the monetary policy being rather too loose. Nonetheless, the Japanese case suggests an important conflict between monetary policy and prudential regulation. This issue will become even more important as we discuss the possibility of expanding the regulatory role of the Federal Reserve.

11 Responses to "Central Bank as the “Market-Maker of the Last Resort”"

  1. Akiraka na arawanikoto   May 20, 2008 at 8:15 am

    Open Market Operations have extended well beyond monetary policy, regulation, or even private cajoling of market players. US CB in concert with President’s Working Group on Financial Markets is actively intefering in capital markets. They are significantly muting the free market actions of the millions of large and small investors. Doing so in order to buy time to implement workouts to financial distress and to avoid a double whammy of deflationary spirals, i.e. RE & investments. They pay a price in loss of market confidence, loss of faith in government sponsored economic indicators, and general unease due to negative real borrowing rates, commodity inflation, stock price propping. All due in whole or part to activities by these actors or their cohorts in finance.While CBs may have become the "Market Maker of last resort" stemming a recessionary tide even if momentarily, they have certainly become Market breaker of last resort for short-sellers. Where "nationalize losses, privatize gains" becomes hard party line, and stock markets only trade up or sideways even on horrific news, and while simultaneous currency debasement and inflation chip away at nominal investment values and savings, Global investors are often forced to forego ANY gain to obtain security in government bonds. Which is what the US government may well wish them to do anyway. Rope and drive the blind herd to the corral of THEIR choosing. Global equity indexes seem less investment venues than casinos with a racketeering house.

  2. London Banker   May 20, 2008 at 10:11 am

    Many thanks, Takeo, for responding to my objection to the Fed as SuperSIV, or "market maker of last resort". I think what bothers me most is that it isn’t even last resort, but almost first resort as soon as the assets couldn’t be floated in the financial markets as under the conditions prevailing to Q3 2007. The Fed acted very, very quickly to liberalise so as to provide 85 percent monetisation against face value, without any of the consultation and debate that attends most changes in regulation or market operations.As you say, Fed has also slashed interest rates to negative return territory, driving down the dollar and discouraging foreign creditors from financing future deficits or inflows to recapitalise fragile banks. That is going to make the crisis worse in the not distant future.I get the feeling that we are in a manufactured calm, where the Fed has poured what oil it has on the water to provide the illusion of tranquility. Meanwhile those in the know will be preparing for the return of turbulence.Meanwhile, we are beginning to see some segmentation of policy between the Fed and Bank of England. Mervyn King is obviously frustrated with the poor response to his calls for recapitalisation of banks and improved supervision by the FSA. He has stated pretty baldly that he does not expect to cut interest rates anymore with inflation rising steadily, even if it means "one or two" quarters of negative growth. He has also said bluntly that Britons should expect a lower standard of living with higher inflation, lower earnings and tighter consumer and mortgage credit.

  3. eparisi   May 20, 2008 at 11:37 am

    The ECB is aiming at and so far managing to keep the financial system issues separate from the overall price stability objective. They seem to have done everything right so far but the stress in the interbank markets is still not receding. Maybe this time it’s really not the central banks’ fault…

  4. Guest   May 20, 2008 at 2:53 pm

    Dumpster of last resorthttp://www.prudentbear.com/index.php/FeaturedCommentaryHome

  5. Michael   May 20, 2008 at 4:39 pm

    "It is also vital to make progress in structural reform on the economic and industrial fronts through tax reform, streamlining of public financial institutions, and deregulation."Deregulation is a "structural reform" to prevent uncontrolled credit creation, asset bubbles, non-performing loans, credit contraction, deflation, and recession? Deregulation of banking, finance, and industry is exactly what the U.S. has been doing for the last 28 years (along with "tax reform") and as a result we have experienced uncontrolled credit creation, asset bubbles, and non-performing loans. As we now begin to experience the inevitable credit contraction and the Central Bank (Fed) tries to prevent deflation and recession through both negative real interest rates and taking onto its books private toxic assets, the only appropriate "reforms" would restore some order and constraint by the CB on the creation, leveraging, and trading of credit and its derivatives. Such CB discipline is hard to achieve since uncontrolled credit expansion generates huge fortunes and stimulates an upward spiral of investment and business growth. And imposing any order and constraint on the mechanisms of credit expansion restricts the opportunity for fortune-making, investment and business growth. Hence, the modern CB model is to permit an unregulated "cowboy" financial process to create great wealth during the upward spiral of credit creation, and then step in with bailouts and negative interest rates during the subsequent contraction. It’s completely predictable – same process in Japan and the U.S. – and there will be no "structural reform" that includes re-regulating private credit creation unless it comes from politicians outside the central banks and treasuries.

  6. mikmak   May 20, 2008 at 5:30 pm

    The Fed’s preferred measure of inflation, core PCE deflator, advanced 2.070% y/y in March. With the target Fed Funds Rate at 2% and discount rate at 2.25%, real rates are near zero. US Treasury yields have picked up since March 17 though and the real 2-year yield is no longer negative. However, if we use CPIs (core, headline, seasonally adjusted or not) to deflate nominal interest rates, the fed funds rate, discount rate and current short-term Treasury yields would be negative. I don’t see how further rate cuts by the Fed would lower borrowing costs for households during a credit crisis as long as banks are (overly?) cautious about lending and afraid of further losses. Lending interventions seem they’d more effective from this point on. Further rate cuts would weaken the dollar and feed inflation at a time when consumers are already reeling from the housing bust, credit crisis, high food/fuel prices, and lower purchasing power abroad.