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The Absence of Market Forces at the Heart of the Monetary System

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Swiss Finance Institute
on
Friday, June 2, 2017 - 14:00

It is a little appreciated fact that money is issued against collateral. In particular, central banks inject money (or liquidity) into the economy, via banks, in exchange for collateral. Just as banks typically require collateral when they lend to households and businesses, central banks require collateral when they lend (issue money) to banks. The quantity of money a central bank is ready to provide depends on the collateral a bank pledges. In general, better collateral, more money. The exact terms of exchange between money and collateral are determined by policy documents referred to as collateral frameworks. But what kind of assets can banks use as collateral to get money from a central bank?

This simple question does not have a simple answer. The European Central Bank (ECB), for example, accepts around 30,000 to 40,000 different securities. These range from sovereign bonds to unsecured bank bonds and ABSs (Asset Backed Securities), with a large span of ratings and maturities within all asset classes. But what do banks actually put up as collateral?

Naturally, banks prefer to pledge the collateral that gives them the best deal relative to alternative uses. As it turns out, banks use an overweight of the lowest quality collateral possible. From this, we can conclude that the ECB is giving the best deal on low-quality collateral. But what might the consequences of this practice be?

Basic economics tells us that money and resources flow to more profitable trades and ventures. Thus, since the central bank provides money on terms that are relatively more favorable for more risky and illiquid assets, we would expect more of these to be produced in the economy. As an extreme example of this idea, if central bank money is only available against igloos, or igloo-backed securities, then igloos will be built. If the collateral framework favors housing, we run the risk of too much construction and property bubbles. While a policy of favoring illiquid collateral may serve a useful purpose in some situations, it can also promote a misallocation of funds in the real economy. It may also distort money and asset markets by reducing the role of market discipline. And markets are crucial as a mechanism for allocating resources in the economy.

To differentiate between the qualities of collateral, the ECB applies a haircut to each security. This is the difference between the “market value” of an asset and the amount of money a bank can receive in exchange for the collateral. Historically, these haircuts have been revised and updated only every three to four years. Thus, the ECB’s haircuts do not reflect market conditions. What about the “market values” of the eligible securities? As it turns out, around three-quarters of eligible securities do not have market prices. Instead, the central bank calculates a theoretical price. In short, the terms of exchange between money and collateral are set by the central bank with little input from markets. What’s more, banks can also use non-marketable assets such as credit claims. All this helps explain why biases can creep into the system.

Should we be concerned about non-marketable assets, theoretical prices, and stale haircuts? Does it matter that there is little role for market forces or market discipline at the heart of the monetary system?

An absence of market forces and market discipline in a central bank’s collateral framework creates a vacuum at the core of the monetary system for other forces to step into. In the euro area, rating agencies and politics have filled this vacuum. The Eurosystem’s collateral framework and its unconventional monetary policies seem to be a part of a larger political game that is played out on the euro stage among member states.

This article draws on Prof. Kjell G. Nyborg’s Collateral Frameworks: The Open Secret of Central Banksthe first book-length study of the importance of collateral frameworks in monetary policy, focusing on the eurozone and euro crisis.

Interested to find out more?
Register for our free event featuring Mickael Benhaim, Pictet Asset Management; Dr. Andréa M. Maechler, Swiss National Bank; and Professor Kjell G. Nyborg, Swiss Finance Institute and the University of Zurich. The event takes place on 22 June 2017 in Zurich. Register here.

Read other related posts on this topic:
Never Heard of Collateral Frameworks? You’re not Alone
ECB’s Liquidity Injections Distort the Economy