Money Markey Liquidity - how?

With the collapse of Lehman Brothers the BOE have pumped £5 billion into the money markets. But how do they do this?

My ST5 notes says the central bank controls liquidity by changing interest rates and buying/selling bills! I know they haven't changed the interest rate and I don't really understand how they can just buy back £5 billion worth of bills. What if people don't want to sell them back? It doesn't make sense!

So how do they provide this liquidity in practice? Is it a case they just say "Ok, we're are selling £5 billion. You can have it now and pay us back later"? Like commercial paper, but between the central bank and the market as opposed to between companies? Is it still called commercial paper when it's the central bank? Is it called a Bill? Or is this not how it's done?

Are my notes missing something very fundamental?

 

I would imagine they would swap illiquid crappy assets for gilts or bills, which then can be used for collateral for loans

There will probably be a suitable haircut, which may turnout to be inadequate, leaving the burden in increased taxes or increased inflation when the BoE does monetise the debt.

 

Central bank has the "Lender in the last" function as well - it may have increased the credit facility for clearing banks. Not sure if the lender-in-last function has been triggered yet, last time it was mentioned in the press (i think) was just before Northern Rock became property of the Brittish Gov.

The overall market in e.g. 3 month-bills is probably a lot bigger than 5 million - by simply buying 5 bn worth of bills in the open market it will provide greater liquidity as investors in the bills are likely to include a bunch of banks who may be all too happy to sell in return for cash (=liquidity). If the central bank buys bills in the market, it pays cash for them, passing money to investors & increasing liquidity. Similarly, issuing bonds = borrowing in the market which reduces liquidity as cash is invested.

 

I understand how buying/selling bills effects liquidity. I just didn't understand that a central bank could buy them back pretty much instantly. I thought maybe it would be impractical because if they did it on an exchange they would drive the prices up (like in portfolio management).

But what you're saying is £5 billion is just a small drop in the Ocean and actually it is easy to buy back, the bills will be available for repurchase, and it's a smooth almost instant process. I guess they would need to spread that £5 billion around though, so rather than use an exchange deal directly with a number of banks to enusre the liquidity doesn't just go to one bank, but many.

Thanks!

 

Hmmm,

I'm confused now.

When the government wants to increase money supply, it buys bills for cash.
When the government wants to decrease money supply, it sells bills for cash.
Thus it can control the amount of cash that banks have. Is this the right way to think about it?

I have two questions though.

Firtsly, by buying bills, demand for them is increased and the yield on them goes down. Does this have anything to do with how the government controls short term interest rates?

Secondly, isn't the government just trading one very liquid asset for another? Why does it not buy less liquid assets for cash - buying back longer-term bonds, perhaps?

Sorry if this is a stupid question . if it is, can I blame it on my CA1-addled brain?

I really need to get some ST5 done! It's taken a back seat to the CA1 resit lately. In case you're wondering what kind of idiot resits CA1 and does ST5 in the same sitting, I only did it because I'd finished reading ST5 when the results came out. I also thought that sitting two exams would decrease my chance of not passing anything this sitting - kind of like diversification.



Sam

 

I think the point here was to make the money available to those financial businesses that are in danger of failing due to illiquidity (a euphemism for insolvency in this case - forgive my cynicism).

The central bank can either purchase bonds or bills at an appropriate point along the yield curve. This then increases the cash available for lending generally.

If the central bank wants to specifically target lending to someone (ie act as lender of last resort) then it can swap illiquid assets from the firm which is in trouble for T-bills/gilts. The firm can then sell or borrow against the high quality assets and the central bank can buy back the equivalent assets in the market to allow the cash to get to the firm in trouble

 

Thanks Cardno,

So, when the government buys and sells bills, it's not trying to increase the amount of liquid assets in circulation as such - it's aiming to increase the amount of cash available for lending. Banks can't lend out their treasury bills for consumers to go and spend on goods - but they can lend out cash.

In the case of rescuing a specific company, buying that bank's treasury bills won't really help - presumably the company's problems have arisen partly because it didn't have enough treasury bills to begin with.

 

Yes basically. The company in trouble has no high quality assets to pawn

 

doesn't increasing the money supply decrease interest rates??? Isn't this the way that the government sets the interest rate???

 

Ok, so I think the story goes like this (I'd be grateful if someone could correct me if I'm wrong). Sorry if this is quite off-topic; I'm trying to get a complete picture of what's going on.

The public deposits money with banks, which they can get back at very short notice.

The banks then lend out most of that money at longer terms, holding only a small percentage of the original depsoits in reserve. It can do this because it's unlikely that large numbers of depositors will want to withdraw most of their deposits at the same time.

If more depositors than expected want their money back, the bank can borrow at short terms from the money markets (ie. other banks) and use the proceeds to pay its depositors. This is what the core reading means when it says that the main players in the money markets are clearing banks who lend and borrow overnight to control their liquidity.

If they are unable to borrow from the money markets, then they can borrow money from the central bank.

The central bank will act as lender of last resort in order to stop an institution going bust because of liquidity problems.

One thing I've also heard discussed is that the government or central bank can buy illiquid assets from banks in order to provide them with cash. The government/central bank can justify doing this because it does not have the same need for liquidity as the clearing banks.

So when we hear about central banks "bailing-out" failing institutions, as we've been hearing in the news, it really means that they are lending them money to help with their liquidity problems. It isn't the government propping-up loss-making institutions, as some recent discussions in the media seem to have implied. The institutions in question are still solvent and can be expected to be profitable.

The current situation has arisen because banks are cagey about lending to each other because of the uncertainty about the quality of the loans that they have made.

Northern Rock for example was more dependant than most banks on short-term borrowing. As I understand it, Northern Rock was not just making longer-term loans out of the money from it's depositors, but also out of short-term loans from other banks. When it became impossible to borrow in this way, it had to go to the central bank for a loan. When depositors got news about this, they started to withdraw money.

Isn't the role of central bank as lender of last resort supposed to stop such things happening - it's intended to make the public confident that the bank will never go under because of lack of liquidity, and so there's no need to rush to withdraw your deposits before the bank goes bust. If the public just sees borrowing from the central bank as a sign of financial weakness that starts a run on the bank, then what's the point of the lender of last resort facility?

A major liquidity crisis such as this one can cause solvency issues for some - for example - interest rates go up, borrowers default, house-prices crash and some are made insolvent by this reduction in the value of their assets.

Another example I heard was that certain institutions were selling huge quantities of less liquid assets to convert them to cash or more liquid assets - thus reducing the value of the less liquid assets and causing insolvencies for similar reasons.

Sorry this is a long post. I hope it's helpful and I'd be grateful if someone could let me know if I've got anything wrong.

Thanks,



Sam

 

This is a crisis of insolvency not illiquidity.

The central banks supposed role as "lender of last resort", is to lend to illiquid, but solvent institutions, not insolvent institutions. The lax lending over the last 25 years has no parallel in the history of capitalim and there have been plenty of eras of lax lending. The reality is the majority of the banking system is insolvent, either because they have made bad loans themselves or they have used there capital to buy up bad loans that have been packaged up.

What the central banks are trying to do is prevent a debt deflation (http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf). They are propping up insolvent institutions to buy a little time imo.

 

Sorry that link doesn't appear to work. If you google "fisher's debt deflation" then there are a number of good references