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How Central Banks Control More Than You Think

Posted by
Swiss Finance Institute
on
Wednesday, June 14, 2017 - 08:00

Central banks are sometimes said to have a policy to “channel liquidity where it is needed.” While this may sound reasonable, it may also distort markets and the economy, with negative consequences for financial stability and society. What “where it is needed” means in practice may also be infused with political controversy, especially in times of stress.

 

Central banks implement important policies under the radar through their collateral frameworks—the central bank’s policy on which assets it will accept in exchange for issuing money to banks, and what value it attributes to those assets. Which assets are considered acceptable (typically paper assets such as government bonds, bank bonds, and non-marketable credit claims) can affect the supply and value of those assets in the market. For instance, if it is known that central banks attribute the highest value (and are therefore willing to issue the most funds) in exchange for government bonds, wouldn’t government bonds increase in popularity and abundance? The simple answer is yes. 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. In other words, favoring specific assets may stimulate their production which could then produce a serious bubble (and eventually a bursting of that bubble) in the market for that asset.

 

The choice of acceptable assets can also have the effect of supporting banks and sovereigns. A flexible collateral framework can thereby channel liquidity to where it is “needed.” But in doing so, it distorts markets and negatively impacts the price of other assets. The potential for it to work against market forces is clear.

 

Returning to the hot topic of political influence, it is no stretch to recognize that allowing favorable terms to collateral that is held in quantity by banks can be a form of support for those collaterals. The opposite also holds true, of course. And all this means that central banks have more influence than you might give them credit for. It may well be that they have a policy of channeling liquidity to where they want to—as much as to where it is needed.

 

Written by Stuart Garforth, a freelance science writer based in London.

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

 

Read other related posts on this topic:
Never heard of collateral frameworks? You’re not alone
The absence of market forces at the heart of the monetary system
ECB’s liquidity injections distort the economy