Market liquidity disappears when there are no willing buyers, or when the only bids are at prices far below any reasonable estimate of fundamental or fair value. This can happen when the normal purchasers of the instrument vanish or when the market makers malfunction. Starting with the 2007-09 financial crisis and continuing through the Covid-19 pandemic, financial markets faced a series of adverse shocks that severely impacted liquidity. In response, central banks scrambled to update their policy toolkits as enhanced lender of last resort (LOLR) and as market maker of last resort (MMLR) (Buiter and Sibert 2007, Cecchetti and Tucker 2021). To ensure financial stability, safeguard the monetary policy transmission mechanism, and guarantee the continued flow of credit to the real economy, central banks expanded their lending operations to restore funding liquidity and intervened in financial markets directly, purchasing securities to restore market liquidity.
Looking at the actions of 40 central banks for the period from March 2020 to March 2021, Cantú et al. (2021) catalogue 527 interest rate changes, 59 adjustments in reserve requirements and reserve remuneration rates, 143 lending support actions, 101 actions related to exchange rate policy (including swap lines), and 54 asset purchase operations. Advanced economy central banks are clearly less hesitant now to intervene in a variety of markets than they once were. These interventions were on an ad hoc basis.
After all, without well-functioning financial markets and a stable financial system, the monetary policy transmission mechanism would not function properly, and policymakers would not be able to meet their price stability or dual mandates. Rising policy rates aimed at restoring price stability, combined with high public and private sector debt, raises the risk that market liquidity and funding liquidity for systemically important financial instruments and market participants could suddenly disappear once again.
In a recent report of the Advisory Scientific Committee of the European System Risk Board (Buiter et al. 2023), we discuss the implications of lending and market making as a last resort to stabilise systemically important financial markets.
In their traditional lending operations, central banks make loans to banks and a limited range of other intermediaries against a restricted set of high-quality collateral. Today, a much wider range of collateral is accepted from a broader range of eligible counterparties in enhanced lending operations directed at ensuring credit flows to non-bank financial institutions (NBFIs) and non-financial firms. Furthermore, the experience following the 2007-09 financial crisis shows that central banks’ enhanced lending to impaired market makers has often succeeded in restoring their market making capacity, obviating the need for direct purchases. While a credible announcement of a market maker of last resort facility could suffice to stabilise markets without the need for any asset purchases, on a number of occasions central banks (or entities they controlled) acquired bonds outright and expanded their lending operations, both within and across borders.
Reflecting on central bank interventions
Clearly, advanced economy central banks are now less hesitant to intervene directly in markets, purchasing both government and privately issued securities in an effort to stabilise financial markets they view as systemic. At least initially, policymakers considered such policies to be extraordinary measures for extraordinary circumstances. However, as policymakers intervened massively during the 2007-09 financial crisis and in the early stages of the Covid-19 pandemic, markets are likely to expect policymakers to use these instruments again if faced with similar circumstances. As a result, there is now less of a distinction between (permanent) standing facilities that are only active in exceptional circumstances and ad-hoc strictly temporary facilities.
Our report begins with the observation that central banks are now extensively employing enhanced lender of last resort and market maker of last resort facilities, often putting them in place quickly and in a manner that leaves little time to reflect on their design and structure. With that in mind, we reach the following conclusions:
- The enhanced lender of last resort and the market maker of last resort are public sector entities (or government-funded and government-guaranteed entities) that aim to ensure that systemic financial markets for domestic currency denominated securities remain liquid.
- An important justification for having enhanced lender of last resort and market maker of last resort facilities is that, in addition to their central role in the monetary policy transmission mechanism, financial markets are increasingly becoming a significant source of financial and systemic risk.
- Establishing an enhanced lender of last resort or market maker of last resort creates moral hazard, encouraging excessive risk taking and distorting prices. Reducing risk-taking incentives and minimising the impact on prices requires that authorities strike a complex balance. The cost of borrowing from the enhanced lender of last resort or selling to the market maker of last resort should be set at penalty terms, so that both options are unattractive in normal times but appealing relative to the expensive (or non-existent) alternatives in stress periods. In addition, rigorous regulation and supervision during normal times of those that may benefit from enhanced lender of last resort and market maker of last resort facilities can further mitigate moral hazard during periods when markets are disorderly.
- It is essential that the enhanced lender of last resort and the market maker of last resort have balance sheets that can expand quickly, lending to qualified counterparties or purchasing securities in almost unlimited amounts. This means that the enhanced lender of last resort and the market maker of last resort must be either the central bank itself or an agent with unlimited access to the central bank whose solvency is unquestioned.
- The evidence suggests that in many instances, authorities can achieve their market stabilisation objective either as an enhanced lender of last resort, lending in domestic currency to regulated private agents acting as market makers or as normal purchasers, or as a market maker of last resort that stands ready to buy any quantity of a given domestic currency denominated security offered at a set price.
- The enhanced lender of last resort and the market maker of last resort are capable of achieving the same stabilisation goal except in the following circumstances: (1) when concerns about the quality of the securities cause the market to disappear, (2) when private market makers become concerned that they will be the only participant left in a market as a buyer, (3) when regulatory constraints on balance sheet size bind, (4) when speed is of the essence, and (5) when it is impossible for the authorities to establish the solvency (or identity) of potential borrowers. Under these conditions only the market maker of last resort can do the job.
Desirable attributes of a framework for stabilising financial markets
Since authorities may feel compelled to use both facilities again, we ask how they might design an enhanced lender of last resort and market maker of last resort to maximise their effectiveness while minimising the damage that they might cause. This leads us to develop a set of desirable attributes.
- Be transparent and clear. When lending or buying, explain the objectives, instruments, and terms, and provide a clear justification for the establishment of the facility. If the purpose of a facility changes, describe what is happening and provide a justification. Note that a facility can serve multiple objectives at the same time.
- Support only financial markets deemed essential. In the choice of target markets and instruments, be clear that the purpose of interventions is to address financial stability risks. The aim is to address market dysfunction, not to steer credit to favoured sectors, firms, individuals, or governments.
- To be able to ascertain their solvency, lend only to regulated and supervised counterparties. As a market maker of last resort, buy from all sellers that can reliably deliver, say by insisting on delivery versus payment.
- Set up facilities so that counterparties initiate loans and purchases. For lending, offer loans with clear terms and let borrowers choose whether and how much to borrow. For purchases, set a price and offer to buy however much sellers wish to sell.
- Develop and maintain an ongoing capacity to price often illiquid securities that could be accepted as collateral in a lending operation or be purchased outright.
- Control moral hazard by offering pricing that would be unattractive in normal times. Lending rates and haircuts should carry costs that are high in normal times. When purchasing outright, offer to buy at prices that are below the bids offered when financial markets are operating normally.
- Lend or buy as little as possible and, when feasible, sterilise the interventions to distinguish them from expansionary monetary policy.
- Recognise that credible announcements may reduce the scale of required interventions. Experience suggests that when markets become illiquid and market participants believe the central bank will lend or purchase a sufficiently large amount, it may not be necessary for the central bank to do much.
- Exit quickly while minimising the impact on asset prices. Have an announced policy in place that establishes the timing and trajectory for normalisation (including the sale of assets acquired through the market maker of last resort operation and the unwinding of loans made through the lender of last resort operation).
- Control balance sheet risk. State clearly who bears the credit and market risk associated with the transactions. Indicate whether the fiscal authority is providing indemnification or whether losses will be borne by the central bank.
Final considerations
To conclude, given that central banks are likely to continue to intervene, it is essential that we continue refining a framework for stabilising systemically important financial markets. First and foremost, we need an agreed-upon procedure for determining which markets are systemic and deserving of central bank support. Any decision to intervene requires judgement on whether these markets are strictly necessary for a well-functioning financial system, as well as an understanding of how financial markets are related to each other and how financial market disruptions can influence the real economy and the operation of the monetary policy transmission mechanism. Second, central banks need to develop a continuous capacity to price securities when markets disappear. Collateral frameworks already require estimation of fundamental values, but these will need to be expanded to include valuation of a potentially wider set of securities. Third, an appropriate expansion of counterparties, likely including non-bank financial institutions, need to be identified for the enhanced lender of last resort. Fourth, decisions need to be made about whether enhanced lender of last resort and market maker of last resort facilities should remain ad hoc or become permanent but usually dormant facilities. Finally, facilities need to be structured in ways that mitigate moral hazard. This means improving our understanding of how we can adjust the prudential regulatory and supervisory regime to reduce the reliance of financial intermediaries on the central bank backstop in episodes of illiquidity.
References
Buiter, W, S Cecchetti, K Dominguez and A Sánchez Serrano (2023), “Stabilising financial markets: lending and market making as a last resort”, Reports of the Advisory Scientific Committee, ESRB, No 13, January.
Buiter, W and A Sibert (2007), “The central bank as the market maker of last resort: from lender of last resort to market maker of last resort”, VoxEU.org, 13 August.
Cantú, C, P Cavallino, F De Fiore and J Yetman (2021), “A global database on central banks’ monetary responses to Covid-19”, BIS Working Paper, No 934, March.
Cecchetti, S and P Tucker (2021), “Understanding how central banks use their balance sheets: A critical categorisation,” VoxEU.org, 1 June.
de Guindos, L and I Schnabel (2020a), “The ECB’s commercial paper purchases: A targeted response to the economic disturbances caused by COVID-19”, The ECB Blog, 3 April.
de Guindos, L and I Schnabel (2020b), “Improving funding conditions for the real economy during the COVID-19 crisis: the ECB’s collateral easing measures”, The ECB Blog, 22 April.
