Appendix 1. Collateral and the 2007-08 Market Turmoil
Appendix 2. United States Collateral Framework
Appendix 3. The Eurosystem Collateral Framework—Bank Loans
Appendix 4. United Kingdom Collateral Framework
Appendix 5. Risk Control Measures (as of May 2008)
Asset Backed Security
Basel Committee on Banking Supervision
Banque de France
Bank for International Settlements
Bank of Canada
Bank of England
Bank of Japan
Committee on the Global Financial System (BIS committee)
Collateralized Mortgage Obligation
Central Securities Depository
European Credit Assessment Framework (ECB)
European Central Bank
U.S. Federal Reserve Bank
Long-Term Refinancing Operation (ECB)
Mortgage Backed Security
Ministry of Finance
Main Refinancing Operation (ECB)
Nonbank Financial Institution
National Central Bank (part of the Eurosystem)
Open Market Operations (undertaken at initiative of central bank)
Over the Counter
Primary Dealer Credit Facility
Reserve Bank of Australia
Retail Mortgage Backed Security
Standing Facility (used at initiative of commercial bank)
Small and Medium-sized Enterprises
System Open Market Account (securities portfolio held by the Fed)
Term Auction Facility
Term Securities Lending Facility
Euro OverNight Index Average
Bank for International Settlement, 2001, “Collateral in Wholesale Financial Markets, Risk Management and Market Dynamics,” CGFS Reports, (March). http://www.bis.org/list/cgfs/tid_50/index.htm
Bank for International Settlement, 2008, “Liquidity Risk Management and Supervisory Challenges,” BIS, BCBS Reports (February) (pp. 4 on Collateral Usage).
Bank of Japan Quarterly Bulletin, 2003, “The Bank of Japan’s Eligible Collateral Framework and Recently Accepted Collateral,” (May).
Bindseil, U., Papadia, F., 2006, “Credit Risk Mitigation in Central Bank Operations and its Effect on Financial Markets: the Case of the Eurosystem,” European Central Bank Occasional Paper No. 49 (August).
Chailloux, A., Gray, S., Klüh, U., Shimizu, S. and Stella, P. 2008, “Central Bank Response to the 2007–08 Financial Market Turbulence: Experiences and Lessons Drawn,” IMF Working Paper 08/210 (Washington: International Monetary Fund).
Estrella, A., 2002, “Securitization and the Efficacy of Monetary Policy”, Federal Reserve Bank Economic Policy Review, Volume 8, Number 1
European Central Bank, 2007, “The Collateral Framework of the Federal Reserve System, the Bank of Japan and the Eurosystem,” ECB Monthly Bulletin (October).
Fitch Ratings, 2008, Europe Special Report, “The role of the ECB: Impact of Increased Liquidity on European Financial Markets and Banks,” (May).
Sauerzopf, B, 2007, “Credit Claims as Eligible Collateral for Eurosystem Operations,” Oesterreichische Nationalbank, Quarterly Report, second quarter 2007. http://ideas.repec.org/a/onb/oenbmp/y2007i2b4.html
The authors would like to thank participants in the MCM seminar held on June 19, 2008; Peter Stella, Adnan Mazarei, Laura Kodres, Geoffrey Heenan, Seiichi Shimizu, Imène Rahmouni-Rousseau and Arnaud Marès for useful comments and discussions.
A separate Working Paper, “Central Bank Response to the 2007-08 Financial Market Turbulence: Experiences and Lessons Drawn”, gives broader coverage of the operational issues faced by central banks during the turmoil.
“Quite understandably, [central bank counterparties] have economized on the use of central government bonds which has been often almost the only collateral counterparties could still use in interbank repo markets. Instead they have brought forward less liquid collateral…including ABSs, for which primary and secondary markets have basically dried up.” José Manuel González-Páramo, ECB Executive Board Member, June, 2008.
The U.S. Fed and the Bank of Japan both have large, long-term outright holdings of securities broadly to match cash in circulation. Some central banks do purchase a lot of foreign exchange outright, but this is predominantly for exchange rate management purposes, not for liquidity provision.
Stella, P., Lonnberg, A., 2008, “Issues in Central Bank Finance and Independence,” IMF Working Paper 08/37.
Rejecting or charging higher interest rates to counterparts based on individual creditworthiness, and particularly on a change in perceived creditworthiness, would give market signals very damaging to the institution.
Unsecured lending may also raise some criticisms on the use of insider knowledge acquired through a central bank’s supervisory role.
If “BestBank” can borrow at Libor in the market, and “WorstBank” at Libor plus 25bp, then—assuming that Libor is at least a few basis points above the central bank short-term OMO rate—“WorstBank” will bid above Libor for central bank funds, whereas “BestBank” has little incentive to do so.
If the monetary policy decision of the central bank typically considers changes to official rates in steps of 25bp, it would be odd if changes in the opportunity cost of collateral could impact the result of OMO auctions by a similar amount.
Other than general legislative provisions—in some countries—for the government to re-capitalize the central bank in case of need.
That is, bought outright, at a discount rate reflecting the desired interest rate. Where such bills had already been traded once—in some cases a requirement for eligibility—the practice was referred to as re-discounting.
John Law, “Money and Trade Considered”, 1705.
Interestingly John Law’s spectacular bankruptcy in 1715 in France was not perceived as an illustration of the fallacy of the Real Bills doctrine.
Henry Thornton, “An Enquiry into the Nature and Effects of the Paper Credit of Great Britain”, 1802.
The hyper-inflation experienced in Germany in the post World War I era was attributed in part to the Real Bills doctrine.
Federal Reserve Board 10th Annual Report, 1923: “It is the belief of the Board that there is little danger that the credit created and distributed by the Federal Reserve Banks will be in excessive volume if restricted to productive uses”. Productive use here meant loans to finance production and marketing of actual goods.
Short-term self-liquidating bills (Handelswechseln), typically used to finance the purchase of physical goods (inventory or inputs) which should quickly generate a cash-flow to repay the financing.
For instance, the Fed has occasionally adjusted its collateral policy based on sectoral considerations. In 1934, it allowed open-market purchases of acceptances of the National Agricultural Credit Corporation, obligations of the Federal Farm Mortgage Corporations, reflecting Congress’s intention to support the agricultural and housing sectors of the economy. Similar measures were taken in 1966 when the Federal Reserve was authorized to deal in agency obligations of the Federal National Mortgage Association (FNMA) and of the Federal Home Loan Bank (FHLB).
The Discount Window involves collateralized lending, not discounting, despite the (historic origin of) the name.
The ECB 2007 Annual Report refers (p101) to “The concept of adequacy [of collateral] implies, first, that the Eurosystem is protected from incurring losses in its credit operations and, second, that sufficient collateral should be available to a wide set of counterparties, so that the Eurosystem can provide the amount of liquidity it deems necessary through both its monetary policy and payment systems operations.”
Perhaps by several thousand times: an exact figure is not possible as eligibility is not always judged until an asset is discussed with the relevant regional Fed.
Commercial bank reserves held at the Fed are typically 1-2 per cent of the Fed’s balance sheet. For the Bank of England the figure is around 25 per cent.
In principle 2,000 financial institutions may participate in the Eurosystem OMOs and 2,700 use standing facilities.
The BoJ, like the U.S. Fed, roughly matches currency in circulation with outright holdings of domestic currency government securities.
Generally characterized by some combination of the following: uncontrolled central bank lending to the government or large accumulation of quasi-fiscal assets, high reserve requirements, or structural excess liquidity, typically leading to high inflation, substantial banking spreads and quasi penalty interest rates on customers.
“High reserve money intensity” can be seen as the ratio of commercial banks’ current account holdings with the central bank related to the size of its balance sheet. This ratio can be high because of high reserve requirement (for countries with a structural liquidity deficit), or because of an excess liquidity environment. Countries with “low reserve money intensity” are those where the central bank implement monetary policy with a small amount of commercial banks balances related to the size of its balance sheet.
The market has to borrow from the central bank—or sell it assets outright—in order to finance purchases of notes on behalf of customers.
For instance, the Bank of England could accept U.S. Treasuries, or a U.S. dollar bond issued by another suitably-rated European government.
On September 4, 2008 the ECB announced, amongst other technical updates to its collateral system, that “The definition of ‘close links’, as given in Section 6.2.3 of the General Documentation, will be extended to include situations in which a counterparty submits an asset-backed security as collateral when it (or any third party that has close links to it) provides support to that asset-backed security by entering into a currency hedge with the issuer or guarantor of the asset-backed security or by providing liquidity support of more than 20% of the nominal value of the asset-backed security.”
As an exception to this general approach, the BoE’s 3-month maturity OMO has, since December 2007, also accepted some securitized assets which are not eligible for other OMO or for SF.
The U.S. Discount Window Rate is fixed by reference to the Fed funds target rate, but not by reference to the Fed’s OMO transactions; the latter can vary, at times substantially, from the target rate. The Eurosystem likewise fixes the SF rates by reference to the minimum bid rate at short-term OMO, rather than the outturn of the OMO auctions themselves.
This might be similar to the setting of Standing Facility rates. Normally a credit SF is sufficiently above the policy rate to encourage the market not to use it; but in times of market disruption it deliberately sets a ceiling to market spreads.
The Bank of Canada did this in August 2007, allowing the use of the SF collateral pool in its short-term OMO.
The U.S. Federal Reserve did this in 2007-08, reducing the spread of Discount Window operations over the target rate on two occasions.
Eligibility criteria, collateral valuation and haircuts address the credit risk.
Market risk refers to the potential change in prices during the course of a loan, exogenous to the unwind of a collateral position. Liquidity risk refers to the potential price effect caused by an attempt to quickly unwind an outstanding position.
Ideally, collateral should be marked to market daily; in some markets this is done less frequently because of data problems, and in such cases the haircut may be larger to offset the longer periods between mark to market.
Unusually, in this case the loan was in foreign currency while the collateral was domestic-currency denominated.
For instance, the Fed relied heavily on Bear Stearns’ own valuation assessment as part of the $29 bn loan extended to the firm on March 24, 2008.
An assessment on firms’ risk management practices found that VaR calculations based on data collected during the financial crisis were 10-200 percent higher compared with earlier VaR calculations that covered more favorable market conditions, owing to incorrect assumptions on volatility. See Senior Supervisors Group, “Observations on Risk Management Practices during the Recent Market Turbulence,” March 6, 2008.
It may be a moot point whether central bank credit operations involve a subsidy by providing credit more cheaply than available elsewhere, or whether they help to correct a situation where (short-term) market failure leads to overpricing of some transactions.
The report, published in January 2007, highlighted the two following key elements: “(i) Accepting foreign assets as collateral, either routinely or only in extraordinary circumstances, is an option that central banks could take in order to address commercial banks’ intraday liquidity requirements…(ii) …the diversity and complexity of domestic financial markets, liquidity usage, and the operational structure of G10 central banks suggest a wide range of approaches regarding whether… it would be appropriate for an individual central bank to take cross-border collateral. Thus, the G10 central banks agreed on adopting an ‘à la carte approach’, under which it is left to each central bank at this stage to decide independently its policies on foreign collateral…”
With the caveat that, for purely liquidity management reasons: (i) several central banks provided additional reserves for a few days at the immediate onset of the crisis; (ii) liquidity provision was at times frontloaded within the maintenance period (with an offset toward the end of the maintenance period, whether via tighter allotment decisions or liquidity draining operations – see section III.A in WP08/210, ‘Central Bank Response to the 2007-08 Market Turbulence’); and (iii) some smaller central banks increased the supply of reserves for several months.
The cut-off rate in the short-term monetary policy OMO (the 7-day maturity MRO).
One loophole could consist for bank A to issue large amounts of bonds to be placed with bank B, while bank B would issue matching amounts to bank A, both using the thus acquired securities to access central bank liquidity provision. Banks facing similar LIBOR funding costs could thus “create” an easy and “cost-free” access to central bank liquidity. Of note, bank bonds issuance has surged to unprecedented levels for the euro-area in April 2008. That said, some central banks (e.g., RBNZ) may opt to accept bank-issued securities, in part to bolster confidence in the bank bond market.
See Chailloux et al. (2008) for a more detailed discussion on the central bank response to the crisis and challenges to their respective exit strategies.
To some extent this may be reasonable e.g., Fed Vice Chairman Don Kohn, who stated that: “central bank liquidity facilities are intended to permit those with access to hold smaller liquidity buffers, which allows them to fund more longer-term assets and thereby promotes capital formation and economic growth.” (Speech at FRBNY-Columbia Business School conference, May 29, 2008).
One illustration of the likely market impact in times of stress is the central bank’s willingness to accept less liquid collateral (e.g., certain mortgage-related securities during 2007-08). Such access to central bank liquidity may help to prevent fire sales of illiquid assets, suggesting that the eligibility premia may stem excessive price declines in the market. It is a moot point whether this delays market price discovery, or substitutes for a failure of the market mechanism. Likewise, post-crisis accommodation of poor quality collateral can also lengthen the process of getting the market “back on its feet,” especially if distressed-asset refinancing by the central bank is not discriminative enough.
Fitch Ratings, May 2008, Europe Special Report, “The role of the ECB: Impact of Increased Liquidity on European Financial Markets and Banks”. This report emphasized the impact of ECB standards for the eligibility of RMBS, noting “such instruments being increasingly structured for use as ECB collateral since August 2007…”, and that “…ECB-driven issuance has also carried relatively low coupons that would be unrealistic if they were to be placed with investors in the current market-as indicated by much wider credit default swap spreads.”
Citigroup Industry Flash, March 2008, “Who is borrowing from the ECB ?” This report also emphasized the market impact of Eurosystem eligibility rules: “This funding route may hamper recovery of public ABS market – Banks have no incentive to return to the public ABS market since ECB funds are so much cheaper…”
The Fed and the BIS have raised concerns on the potential market impact of collateral eligibility decisions. See for instance Federal Reserve (2002) “The fact that the Federal Reserve Portfolio consists largely of Treasury securities has enabled the Federal Reserve to maintain neutrality…If the Federal Reserve was to conduct the bulk of its operations in assets other than Treasury securities, the risk of affecting relative prices across assets could be significant, although strategies employing substantial diversification and carefully designed trading rules could greatly reduced these effects.” Likewise, the BIS in its 2006 report on “Cross-border Collateral Arrangements,” BIS CPSS, January 2006, asserted that: “A particularly high percentage usage, for example, might suggest that banks’ requirements for eligible assets to back central bank credit are a principal driver of demand in a particular market segment, potentially having a marked effect on pricing, and raising concerns about accessibility/availability of additional assets.”
The collateral intensity (and the related market impact) may be magnified depending on the magnitude of the market disruption. As the price of the asset is set by the marginal transaction, the collateral policy of the central bank should only affect prices in the event of rationing. The disruption of trading represents a potential case of rationing that would give the central bank’s refinancing option greater impact in the price setting-mechanism (where the central bank transaction actually becomes the “marginal transaction” or, alternatively viewed, prevents the occurrence of a fire sale marginal transaction which might impact the price sharply).
German securities backed by a pool of mortgage loans.
“…several of the Federal Reserve’s new programs are designed to be self-liquidating as markets improve. Minimum bid rates and collateral requirements have been set to be effective when markets are disrupted, but to make participation uneconomic when markets are functioning well.” – Don Kohn, May 29, 2008.
This would include assets available in the market, rather than just those held by the commercial banks; but there are some difficult issues here. It is hard to measure nontradable collateral (e.g., loanbook assets) since the central bank may not know which loans meet eligibility criteria unless they are pledged to the central bank; and if foreign assets are eligible, the outstanding volume may be very large, but only a small amount may be available to the domestic financial system.
A system of averaging around zero (with full collateralization of any overdraft) may be operationally equivalent – from a liquidity management point of view - to averaging with a positive targeted level of reserves, but is less collateral intensive.
The report published in January 2007 by a CPSS working group of the BIS noted: “Some forms of coordination and cooperation among central banks may increase the effectiveness of an individual central bank’s policies and actions, or may aid the private sector in developing more advanced tools for managing collateral and liquidity…”
In fact, the Eurosystem saw a reduction in the number of OMO participants in individual operations.
Use of the SF peaked at $2.25 billion and $4.8 billion, respectively (on 27 December for the latter), compared with previous usage of up to $0.5 billion.
The end-of-year peak in Discount Window borrowing was dwarfed by the recourse to the PDCF in the last week of March 2008 ($38 billion).
With the exception, since December 2007, of the inclusion in its 3-month OMO of certain securitized assets which are not eligible in other operations.
Unlike the Fed, OMO counterparties may also access SFs.
Indeed, the $4.4tn Treasury market would sufficiently meet liquidity needs, though a return to budget surpluses, which could lead to a scarcity of Treasuries, is part of the reason the FRS continues to accept agency debentures and agency-guaranteed MBS, in addition to Treasuries. While participation in these other markets may increase the FRS’s credit risk, they also provide insights into market conditions that could not otherwise be achieved.
The Federal Reserve Act does not explicitly authorize the use of other collateral in repo transactions, but it also does not explicitly forbid it. Indeed, during the turn of the year in 2000, the Board of Governors authorized the New York Fed to write options in order to forestall problems.
The major regulators rely on a loan classification that includes categories such as pass, substandard, doubtful, loss, and special mention. (For more information on this, see the federal financial examinations council at www.ffiec.gov). The FRS then converts the regulators’ classification to its own two-tiered system. See footnote 79 for further details.
Primary credit is extended (generally) without restrictions to institutions in sound condition for a term up to 30 days at a rate typically 100 bps above the policy rate (although in August 2007 the spread was narrowed to 50 bps due to market conditions, and to 25bp in March 2008). Secondary credit is available to financial institutions that are not eligible for primary credit, as a backup source of funding on a very short-term basis, or to facilitate an orderly resolution of serious financial difficulties. Such loans are extended at a rate above the primary credit program and entail a higher level of Reserve Bank administration and oversight than primary credit. The seasonal credit program is designed to address funding needs of smaller institutions experiencing regular swings in their deposits and loans. Only institutions with less than $500 million in total domestic deposits are eligible. Borrowers must demonstrate a seasonal funding need that lasts for at least four weeks and meet a portion of their funding from market sources. The rate charged on seasonal credit is based on the average of the federal funds rate and the ninety-day certificate of deposit rate over the previous reserve maintenance period. For further details, see http://www.frbdiscountwindow.org/programs.
The FRS is authorized to extend credit to individuals, partnerships, and corporations against Treasury and agency securities for up to 90 days under “unusual or exigent” circumstances. There are strong limitations to emergency lending: (1) they must be approved by at least five members of the Board of Governors, (2) they can only occur when no other market funding sources are available, and (3) failure to provide credit would have adverse effects on the economy. See Section 13(3) of the FRS Act for further details: http://www.federalreserve.gov/GeneralInfo/fract/.
For instance, a 14-day repo unwinds each business day, meaning that the cash and collateral swap places and the trade is rebooked on a daily basis. This is to ensure that the collateral is properly priced everyday, although it also makes the operations more burdensome for term repos.
Haircut calculations are based on a combination of changes in asset prices from duration and convexity calculations, interest rate volatility, credit spread volatility, and liquidity differences between marketable and nonmarketable assets. The amounts are re-evaluated every 12-18 months, or more frequently, if warranted. For further details, see pp. 3-14 to 3-15 in www.federalreserve.gov/BoardDocs/Surveys/soma/alt_instrmnts.pdf.
For details on the Federal Reserve’s indemnity agreement with the FDIC, see Federal Deposit Insurance Corporation Improvement Act of 1991 and James Clouse, “Recent Developments in Discount Window Policy,” Federal Reserve Bulletin, November 1994.
The FRS utilizes a system shared by most of the major regulators. Within the immediate domain of the Discount/Credit Risk part of the FRS System, a two-tier rating system is used, which classifies commercial loans as “normal risk” (loans rated B to BBB-) and “minimal risk” (loans rated BBB- and higher). Within each risk category, assets are categorized by maturity and a standard haircut is then applied to the book value of all assets in each risk and maturity category.
The first discussions as to whether and how bank loans could be accepted throughout the Eurosystem were held in 2002. Although all NCBs were ready in January 2007 to take bank loans, some do it only under fairly restrictive terms (e.g., a minimum size of 2 million euros) and will not shift to a broad-based acceptance until 2012.
Note however that some countries also use an earmarking system, whereby individual underlying assets are associated with individual transactions.
Equities were—unusually—also eligible in Spain, but were eventually phased out in 2005 due to very low use.
In addition, ABS/MBS raise other challenges in terms of valuation and complexity.
For more details, see annex 7 of the General Documentation.
RTs have been developed by the three main rating agencies (Moody’s, S&P, Fitch) and are based on country specific tested quantitative models. They are not in use for assessing bank loan debtors as they have not been validated yet by the Eurosystem.
Defined as corresponding to a probability of default no higher than 0.10 percent over a one-year horizon.
There was however, a heated debate in the preparation phase as to whether international rating agencies ratings should take precedence over all other rating sources.
Italy and Belgium are the countries with the highest level of public debt as a percentage of GDP in Europe.