Back Matter

Glossary

ABS

Asset backed securities

AE

Advanced economies

AMLF

Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility

APF

Asset purchasing facility

BoC

Bank of Canada

BoE

Bank of England

BoI

Bank of Israel

BoJ

Bank of Japan

CE

Credit easing

CHF

Swiss franc

CPFF

Commercial paper funding facility

ECB

European Central Bank

ETF

Exchange traded funds

Fed

Federal Reserve

FOMC

Federal Open Market Committee

FX

Foreign Exchange

GSE

Government-sponsored enterprise

LIBOR

London Interbank Offer Rate

LTCM

Long Term Capital Management

LTRO

Long-term refinancing operations

MBS

Mortgage backed securities

OIS

Overnight indexed swap

PRA

Purchase and Resale Agreements

QE

Quantitative easing

RBA

Reserve Bank of Australia

REIT

Real Estate Investment Trust

SNB

Swiss National Bank

TAF

Term Auction Facility

TALF

Term Auction Lending Facility

TED

Treasury Bill Rates

TSLF

Term Securities Lending Facility

VAR

Value at risk

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Appendix I. Central Bank Liquidity Support for Individual Financial Institutions During the Recent Crisis

106. During the recent crisis period, several major central banks extended liquidity support for individual financial institutions. These were to prevent a disorder failure of systematically important financial institution from causing serious harm to the economy. This support is a time-honored tool of central banks going back to the 19th century or earlier. This policy rests on the ability of the central bank to generate reserve money as well as its informational advantage allowing it to judge that an individual institution is illiquid rather than insolvent (the latter is a fiscal responsibility) and that its failure could have systemic consequences and thus requires public support.

107. A few countries provided significant amount of liquidity support for individual financial institutions during the recent crisis. The BoE and SNB extended emergency loans to banks, the traditional recipients of emergency liquidity support. The Fed provided liquidity support to non-bank financial institutions, which are more atypical for the central bank. The liquidity support extended by BoE has already been repaid and that by the Fed and SNB have been decreased gradually.

108. As those loans pose a potential high credit risk, central banks protected their balance sheets in various ways. The emergency loans extended to specific institutions during the recent crisis have all been collateralized. The UK government provided loss-protection and in the U.S. and Switzerland private institutions committed to take certain amount of first losses.

109. Preventing moral hazard is an important element in designing those loans. A traditional approach to prevent moral hazard is to extend loans at a penalty rate. All the liquidity support extended to specific institutions during the crisis period was at higher than the market rates. The Fed provided controversial liquidity support to American International Group and at the same time “worked with AIG to replace its management.”

110. The timing and elements of disclosure of those loans have differed across the cases, largely depending on the possible impacts on the markets’ confidence on the conditions of the troubled institution. The BoE delayed the disclosure of the terms and conditions, or even the names of the recipient of the loan, when the bank extended emergency loans to ongoing entities (Royal Bank of Scotland and HBOS). When the liquidity-receiving institution is under public resolution scheme or when the disclosure of emergency credit extension could buttress the confidence to the institution, there would be no reason to hold back the information (the Fed and SNB).

111. In general, the liquidity support to troubled institutions seems to have helped forestall systemic stress (Figure 13). In two out of four cases in which the liquidity support was announced immediately, the stress in interbank markets seemed to be alleviated after the announcement. For other two cases, the effectiveness of the liquidity support is hard to measures as those two cases occurred in the middle of the severe stress following the collapse of Lehman Brothers.

Figure 13.
Figure 13.

Changes of Libor-OIS Spreads from the Event Day 1/

(Basis Point)

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A999

1/ The event day for each case of liquidity support are as follows: September 17, 2007 for Northern Rock, March 16, 2008 for JP Morgan/Bear Stears, September 16, 2008 for AIG, and October 16, 2008 for UBS.

Appendix II. Unraveling Financial Risks of Bond Purchase

112. While bond purchases seem to have lowered yield curves on impact, the effects do not come without costs. Central bank bond purchases generate a maturity mismatch between large amounts of long-term assets and short-term liabilities. This makes the balance sheet vulnerable to increases in interest rates. Further, bond purchases shorten the duration of the liabilities of the consolidated public sector balance sheet, which could increase ex-post public financing costs in the case of unexpected rises in interest rates.

The impact of bond purchases on the financial position of the central bank

113. A central bank can incur financial losses from bond purchase depending on its exit strategy and accounting practices:

  • Income loss—the central bank raises the policy rate and its interest expenses exceed income gains from purchased bonds.

  • Capital loss—the central bank sells outright the purchased bonds at a price lower than the purchase price.

  • Valuation loss—the central bank values the purchased bonds at fair value, and an increase in interest rates lower the value of the bonds.

114. Financial losses can deplete central bank capital and threaten monetary policy autonomy. If losses caused by bond purchases substantially reduce the capital base of the central bank, leaving it dependent on fiscal authorities for funding its expenses, the autonomy of monetary policy could be threatened. This threat to autonomy can be countered by a capital injection. In order to safeguard central bank independence, the gross amount of loss per se matters less than the impact on the capital base. Therefore, if expected losses—which could be computed by a prevailing methodology such as VAR or sensitivity analysis—are smaller than other expected income or capital base, the risks may not be of great concern.37 If the expected loss is relatively large, an explicit and ex ante agreement between central bank and government to secure central bank capital base—agreement to transfer materialized losses or to restore the depleted capital—would be needed to assure monetary policy autonomy.

The impact of bond purchases on the consolidated public balance sheet

115. Central bank bond purchases shorten the maturity of the consolidated public sector liabilities by replacing outstanding long-term bonds with short-term debts (Figure 14). The effect of central bank bond purchases on a consolidated public balance sheet is identical with that of debt management strategy to replace long-term bonds with T-bills (“short-funding strategy”, Figure 14). Hence financial losses incurred by central banks from bond purchase can be viewed as the same as increases in public financing costs when the “short-funding strategy” backfires:

  • Income loss—central bank income losses from a policy interest rate hikes mirror an increase in public financing costs caused by increases in short-term interest rates from a debt management “short-funding strategy.”

  • Capital loss—central bank outright sales of purchased bonds at a loss mirror an increase in public financing costs from the debt manager unwinding a “short-funding strategy” (reissues long-term bonds) when long-term rates are high.

  • Valuation loss—in contrast, a valuation loss does not generate a loss for the consolidated public balance sheet as a valuation loss on the asset side of the central bank is cancelled out by a corresponding gain on the liability side of the government.

116. Another dimension of risks of bond purchase is increased refinancing (rollover) risk due to effective shortening of debt maturity on a consolidated basis. In general, as the debt maturity becomes shorter, the debtor is more likely to face refinancing risks in the event that its solvency is questioned by the market. Of course, a central bank may not face the refinancing risk in a technical sense, as they can issue legal tender that has finality in the payment system. However, the holders of public debts—either those issued by the government or the central bank—may require higher premium or convert them to other currencies, that could make it increasingly difficult and costly to repay those debts. The shorter is the debt maturity, the more vulnerable to such pressures is the debtor.

117. Central bank bond purchases should be driven by its contributions to stable macroeconomic conditions. Bond purchases may increase public financing costs as described above, or decrease them—reduced yield curves during the conduct of bond purchase as well as possible increase in tax revenue due to economic recovery. These effects should be, however, viewed as secondary to the monetary policy objective.38

118. The bond purchase by the Fed and the BoE is estimated to somewhat reduce the maturity of the consolidated sovereign debt (Figure 15). This estimate is made by: (i) constructing the list of outstanding securities of the consolidated sovereign39 by replacing the Gilts the BoE purchased or the U.S. Treasury Securities the Fed is expected to purchase with short-term debts, and (ii) computing the average maturity of this estimate of consolidated public sector debt. The BoE’s Quantitative Easing (GBP200 billion Gilts purchase from March 2009 to June 2010) is estimated to have reduced the average debt maturity of the U.K. public sector by two years. The Fed’s so-called QE2 ($600 billion purchase of U.S. Treasury from November 2010 to June 2011),40 is estimated to have reduced the average debt maturity of the U.S. public sector by six months.

Figure 14.
Figure 14.
Figure 14.

Stylized Balance Sheet—Central Bank, Government, and Consolidated Sovereign

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A999

Figure 15.
Figure 15.

Estimated Maturity of Consolidated Sovereign Debt

Citation: IMF Working Papers 2011, 145; 10.5089/9781455268467.001.A999

Appendix III. Best Practices

119. This appendix elaborates what can be viewed as the best practices of balance sheet policy implementation. Unconventional policies are different in key respects from conventional policies. Thus, establishing best practices for balance sheet policies would be useful to enhance their effectiveness by promoting public understanding of what they aim to achieve, articulating the central bank’s policy choices and considerations, and reducing uncertainties in decision making. They are also meant to help ensure central bank independence and accountability in monetary policy.

A. Objectives, Transparency, and Accountability

1. The objectives and broad framework of balance sheet policies should be clearly set out in terms of the central bank policy mandate.

120. The objectives of balance sheet policies should be consistent with ultimate objectives of the central bank, such as price, macroeconomic, and financial stability. A clear statement of the objectives and operational framework of balance sheet policies helps avoid actual or perceived ad hoc changes to the fundamental priorities of a central bank. Further, explanation of the rational for introducing balance sheet policies, potential risks and risk management measures facilitates transparency by allowing outcomes to be compared with goals, and thus allowing central banks to be held accountable.

Best practices
  • General views of central banks—Senior officials of several central banks that leaned heavily on balance sheet policies made speeches spelling out the objectives and other aspects of their balance sheet policy frameworks (e.g., Bernanke (Fed), April 2009, Smaghi (ECB), April 2009, Trichet (ECB), July 2009, King (BoE), January 2009, and Nishimura (BoJ), October 2010)

  • Financial stability balance sheet policies:

    • Liquidity provision to domestic interbank and credit markets—Many of these measures were announced in a way that distinguished them from changes in monetary policy stance. The Fed’s description of the Term Auction Facility (in December 2007), the Primary Dealer Credit Facility (March 2008), the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (September 2008), the Commercial Paper Funding Facility (October 2008), specified that these were to “help foster improved conditions in financial markets more generally.” The ECB’s covered bond purchase program of May 2009 was “to support a specific financial market segment that is important for the funding of banks and that had been particularly affected by the financial crisis,” and its Securities Markets Program in May 2010 “to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism.”

    • Liquidity provision to domestic foreign exchange markets—The BoC, the BoE, the ECB, the SNB, and the Riksbank’s term dollar liquidity facilities introduced in December 2007 were “to address elevated pressures in short-term funding markets.”

  • Macroeconomic stability balance sheet policies:

    • Bond purchases —The Fed in March 2009 introduced a program to purchase longer-term Treasury securities to help improve conditions in private credit markets. The BOE in March 2009 announced the introduction of an Asset Purchase Facility, as “an additional tool that the Monetary Policy Committee (MPC) could use for monetary policy purposes.”

    • Support to credit— The Fed in November 2008 introduced a program to purchase agency debts and MBSs “to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more general.” The BOJ in October 2010 introduced “comprehensive monetary easing” measures, including a private sector asset purchase program, “to encourage the decline in risk premiums.”

2. The central banks should explain to the extent possible the expected transmission mechanism and risks of balance sheet policies.

121. In comparison with conventional central bank policies, the public is largely unfamiliar with many aspects of unconventional balance sheet policies and transmission is not well understood and highly uncertain. Further, the central bank needs to explain the expected risks of the policies because, as some of balance sheet policies could involve much larger financial risks compared to conventional monetary policy, distortional effects in the markets, and moral hazard with respect to financial institutions and market players. Accordingly, in implementing balance sheet policies, the central bank should explain the policy objectives, as well as the key expected transmission mechanisms including indicators for the appraisal of policy effectiveness.

Best practices
  • In many cases, central banks explained thoroughly how balance sheet policies were expected to contribute to the economy. These explanations have been conducted in various vehicles such as by pamphlet (e.g., BOE’s “Quantitative Easing Explained”); speeches by senior central bank officials (e.g., Fed Chairman Bernanke’s speech at Jackson Hole annual meetings in August 2010 about the Fed’s purchases of long-term securities and BOE Deputy Governor Bean’s speech about quantitative easing); testimony before lawmakers (e.g., Fed Chairman Bernanke’s testimony before a U.S. Senate committee in July 2010, and BOJ’s semiannual report to the Diet); and, analytical reports (BOE Working Paper, The Financial Market Impact of Quantitative Easing).

  • When conducting measures involving larger credit risks than regular operations, most central banks explained how these risks should be managed. The Fed explained its over risk management framework and provided further details on its CPFF and TALF facilities. The BoJ also published its risk management measures: for example, see “Outright Purchases of Corporate Financing Instruments (January 22, 2009).”

3. The central banks should make public the details of the operational design of balance sheet operations, including the terms and conditions of auctions and their actual use.

122. The disclosure of the operational details of balance sheet policies, not only to counterparties but also to the general public, can improve understanding of the objectives, the transmission mechanisms, and the risks of the measures. This information should include a financial statement of assets and liabilities that include specific items from balance sheet policies, auction results of balance sheet policy operations, and outstanding of these operations, by types, maturity, and risk profiles.

Best practices
  • In most cases, key operational features of balance sheet policies (e.g., eligible counterparties, eligible instruments including credit requirements and maturity, pricing including auction mechanisms and collateral margins, frequency of operations) were disclosed to the public. Central banks have disclosed key operational features of unusual operations introduced during the crisis period: see, for example, the case of the Fed, BoE, BoJ, and the Riksbank

4. The central banks should periodically explain progress in achieving policy objectives through balance sheet policies.

123. In light of the unfamiliarity and conditionality of balance sheet policies, central banks should provide the assessment, including progress in achieving the main objectives, their challenges, and prospects for exit strategies. This provides useful information for the market and the general public to assess the performance of the central banks.

Best practices
  • The Fed provided analysis on the effectiveness of their balance sheet measures in several occasions, including in its monetary policy report to Congress, senior officials’ speeches (e.g., Fed Chairman Bernanke’s speech on October 15, 2010), and congressional testimony (e.g., Fed Chairman Bernanke’s testimony before a U.S. Senate committee in July 2010). The ECB issued a monthly report on its covered bond purchase program (Monthly Report on the Euro System’s Covered Bond Purchase Program) through the period when the program is active, while the BoE has published an Asset Purchase Facility Quarterly Report since April 2009.

B. Policy Coordination

5. Financial stability balance sheet policies should be complemented by supervisory and regulatory measures and consistent with the crisis management strategy.

124. The central banks’ counterparties should be limited to regulated and solvent financial institutions. However, when the central banks provide market liquidity support, in response to market strains, there are risks that some financial institutions face not a temporary illiquidity constraint but a solvency problem. Accordingly, the central banks should have timely access to supervisory information about the financial conditions of each of their counterparties. In case of insolvency problem, a bank supervisor and the government should be responsible for supporting or resolving insolvent financial institutions, through various crisis management measures, such recapitalization, purchases and assumptions, and bad bank approach.

Application
  • The Fed and the Treasury issued a joint statement, on March 23, 2009, clarifying that the Fed’s lender-of-last-resort lending should be against collateral with the aim of improving financial or credit conditions broadly and should avoid credit risk and allocation. On May 6, 2009, in the announcement of the Treasury Capital Assistance Program and the Supervisory Capital Assessment Program, key supervisors in the United States, including Treasury and the Fed, stated that the Treasury should be responsible for capital injection.

  • In several economies, central banks’ role in crisis management is set out in the central bank legislation or policy statements (e.g., the Bank of Canada). Generally, the central banks’ role is confined to providing emergency liquidity with adequate collateral to troubled financial institutions, while fiscal authorities are responsible for capital support.

6. Central banks’ balance sheet policies should be clearly delineated from fiscal policies.

125. Balance sheet policies may have much larger budgetary implications for the government than conventional policies. For example, purchasing large amounts of public sector debts by the central banks contributes to lowering yields of public securities, which is also desirable from the perspective of the government’s debt management. However, once the central banks’ policy focus shifts to tightening, there could be a conflict of interest between the central banks and fiscal authorities.41 Some balance sheet policies, such as the purchase of large amounts of private sector securities posing market risk and the remuneration of bank reserves, also have budgetary implications.

126. Accordingly, policymakers should agree on a distinction between monetary and fiscal operations to ensure that the appropriate institution is accountable for its actions and policies are implemented most effectively. Such a clear demarcation is also important to ensure central bank autonomy, particularly because the autonomy is often granted specifically to central banks’ monetary policy functions.

Best practices
  • Many central banks are legally not allowed to purchase government securities in the primary markets (e.g., the BoJ). In the Euro area, the Treaty on the Functioning of the European Union prohibits any type of central bank lending to governments.

  • Central bank senior officials occasionally explained to the public that balance sheet policies are not to monetize fiscal deficits (e.g., Federal Reserve Chairman Bernanke’s speech of May 25, 2010; and BOE Deputy Governor Bean’s answer on quantitative easing).

  • When the BOE launched an asset purchase program, in response to the request by BOE Governor, the Chancellor of the Treasury confirmed that the government’s debt management policy would be consistent with the aim of the BOE’s monetary policy and the government would not change its debt management strategy taking account of the BOE’s asset purchase program.

C. Operational Designs and Exit Strategies

7. Central banks should have sufficient legal and operational flexibility for balance sheet policies.

127. The operational flexibility granted by central bank law is important when the range of operations needs to be expanded, especially in a crisis situation. The operational sphere of balance sheet policies can also shift with changes in the structure of the financial sector. Accordingly, legal and operational frameworks of central banks need to keep up with these changes.

Best practices
  • The old Bank of Canada Act limited the range of central bank operations. As a result, the central bank faced legal constraints in expanding eligible collateral for its liquidity operations. To give the central bank more legal flexibility in conducting open market operations, the Bank of Canada Act was amended on August 5, 2008.

8. Balance sheet policies should be designed to minimize distortions, including moral hazard and resource misallocation.

128. In most cases, balance sheet policies alter the relative price of assets and financing conditions of counterparties and related markets by more than conventional monetary policies. In this sense, balance sheet policies have inherently distortionary impacts. Balance sheet policies should be conducted in a way that such distortionary impacts may neither last unnecessarily long nor exceed the expected benefits. To this end, financial stability policies should build in incentive mechanisms to prevent their misuse by counterparties.

129. Asset purchase programs for macroeconomic stability purpose should be conducted in markets deep and liquid enough to prevent the central banks’ intervention from substantially impairing the market function. In the conduct of credit support for macro-stability purposes, central banks should not be involved in selecting individual borrowers or particular economic sectors as distortionary impacts are extremely high.

Best practices
  • For most of market liquidity support measures, involving private sector assets, the central banks generally charged higher interest rates or set the purchase prices at a level attractive only under stressed market conditions (e.g., the Fed’s CPFF and TALF, BOJ’s corporate bonds and commercial paper purchase facility and BOE’s commercial paper purchase facility).

  • Advanced economy central banks have designed liquidity or credit support measures—either for financial stability purposes or macro-stability purposes—in a way the central banks are not directly involved in the selection of eligible non-financial enterprises, projects, or securities. Instead, the central banks set predetermined criteria (industrial categories, size of the assets, credit ratings, etc.. e.g., the Fed’s CPFF and TALF and BOJ’s Fund-Provisioning Measure to Support Strengthening the Foundations for Economic Growth).

  • In March 2009,42 in the face of “the very weak economic outlook,” the Fed decided to expand MBS purchases expecting that it would provide “greater benefits to the housing sector, and on private borrowing rates more generally,” while also acknowledging that “purchases of Treasury securities…minimize the Federal Reserve’s influence on the allocation of credit.” Later in August 2010, the Fed decided to reinvest principal payments from MBS in Treasury securities motivated by the idea to “minimize the extent to which the Federal Reserve portfolio might be affecting the allocation of credit among private borrowers and sectors of the economy.”43

9. Exit strategies from balance sheet policies should be developed and clearly communicated at the time of their introduction.

130. Balance sheet policies should be implemented on a conditional basis for a limited duration and with a clearly communicated exit strategy to avoid unintended side effects, such as distortion to resource allocations and risks of moral hazard and central bank balance sheet. However, at the same time, unwinding the balance sheet measures should be done gradually and cautiously to preserve market confidence. In particular, if exit dates are preannounced, policymakers need to monitor carefully progress in the wide range of crisis intervention policies and stand ready to alter the dates, if needed. Accordingly, an exit strategy is developed, initially at the time of introduction of balance sheet measures and updated as situations evolve, in close collaboration with other relevant government agencies (e.g., bank supervisors).

Best practices
  • Most central banks that introduced balance sheet measures during the crisis time explained their exit strategies well before actual exits commenced (e.g., Fed Chairman Bernanke, February 2010, ECB President Trichet, September 2009, and BoJ Policy Board Member Mizuno, August 2009).

  • At the time launching its balance sheet measures, the Fed announced their explicit expiration dates, conditional on improvements in market conditions, except for few measures.

  • Many financial stability balance sheet policies, such as the Fed’s CPFF, TALF, BoE’s APF (corporate bonds and commercial paper), and the Riksbank’s term loan facility, include penal pricing to encourage banks to exit from central banks’ liquidity facilities.

  • On bond purchase programs, the Fed and ECB announced both the size of the program and the expected completion date, while the BoE announced only the size of the program.

D. Central Bank Balance Sheet Protection

10. For lending operations, risk management tools, such as collateral, pricing, and haircuts, should be used based on the differential risks of each policy.

131. When a central bank conducts balance sheets policies by extending loans to its counterparties, taking collateral is the most common way to reduce the financial risks of the credit extension. During the crisis period, many central banks broadened the range of eligible collateral but for the newly accepted collateral, if less creditworthy or less liquid, a higher haircut reflecting these risks should be applied to minimize the credit risks.

Best practices
  • The Fed established a framework for collateral eligibility, valuation, and haircuts for each balance sheet policy program.

  • The BoJ introduced several new liquidity facilities consistent with the principles of its collateral policy: namely (i) maintaining the soundness of the BoJ’s assets—with a view to maintaining the soundness of the BoJ’s assets, the BoJ shall only accept collateral with sufficient creditworthiness and marketability; (ii) ensuring smooth business operations of the BoJ and efficient use of collateral; and (iii) utilizing market information—the BoJ shall make effective use of market information, such as ratings in assessing the eligibility of collateral, market prices in calculating collateral prices, and public information in evaluating the creditworthiness of collateral.

11. Private debt instruments for outright purchase or collateral for lending operations should be high quality.

132. When a central bank conducts balance sheets policies by purchasing securities outright, the credit is secured only by the asset purchased. Thus the securities should be high quality investment grades to protect the central bank’s balance sheet.

Best practices
  • On the Fed’s CPFF, the eligible assets were limited to U.S. dollar-denominated commercial paper, including asset-backed commercial paper, with ratings at least A-1/P-1/F1 by a major nationally recognized statistical rating organization, and for its MIFF, eligible financial institutions were limited to those with a short-term debt rating of at least A-1/P-1/F1 from two or more major nationally recognized statistical rating organizations.

  • On the ECB’s covered bond purchase program, eligible assets should have a minimum rating of AA or equivalent by at least one of the major rating agencies (Fitch, Moody’s, S&P or DBRS) and, in any case, not lower than BBB-/Baa3.

  • On the BoJ’s commercial paper purchase program, eligible assets are only those issued by a company rated a-1 by a rating agency.

12. The central banks should have sufficient financial strength and the extent of their risk taking should be agreed with the government, including an ex ante mechanism to transfer resources to the central bank if needed.

Rational

133. Central banks should have sufficient capital and reserves to absorb any losses arising from balance sheet policies.44 In determining the size of the capital and reserves, the central bank needs to evaluate the size of potential losses, their probabilities, and income generating capacity (i.e., segniorage). The central banks’ dividend policies should also be designed to ensure their financial strength, and accounting rules should also allow for appropriate provisioning of expected losses. To preserve financial autonomy, central banks should not introduce balance sheet policies whose potential financial risks could exceed their financial strength, and central bank operations should be confined by the level of its capital and reserves. The central banks and the government should agree on the burden sharing of potential losses.

134. The central bank’s capital may be reduced by losses arising from balance sheet policies. In anticipation of such a risk, a clear rule for central bank recapitalization by the government—including the trigger condition for recapitalization, instruments (typically marketable securities with market interest rates), and timing—should be established.

Best practices
  • On December 16, 2010, the ECB decided to increase its subscribed capital by €5 billion, from €5.76 billion to €10.76 billion, in view of increased volatility in foreign exchange rates, interest rates and gold prices, as well as credit risk.

  • The BoE has implemented an asset purchase facility with the authorization of the Treasury. Prior to the launch of this program, the government, in the open letters between the Chancellor of the Treasury and the Governor of the BOE, agreed to indemnify the BoE and a fund specifically created for this facility from any losses arising out of or in connection with the facility.

  • The Fed established a special purpose vehicle (TALF LLC) to purchase and manage any assets received by the New York Fed in connection with any TALF loans. TALF LLC purchased all such assets at a price equal to the TALF loan, plus accrued but unpaid interest, with the funds first through the fees received by TALF LLC and any interest TALF LLC has earned on its investments. In the event that such funding proves insufficient, the U.S. Treasury’s Troubled Asset Relief Program (TARP) will provide additional subordinated debt funding to TALF LLC to finance up to $20 billion of asset purchases.

13. Measures to protect central bank balance sheets should be clearly communicated.

135. Central banks face greater financial risks in implementing balance sheet policies than in implementing conventional monetary policy. Central banks should not only have appropriate risk management framework in place in implementing balance sheet policies but should also clearly communicate it. This is important to assure the public that balance sheet policies embed appropriate measures to protect the financial position of the central banks, which is important to ensure its policy autonomy.

Best practices
  • The measures to protect central bank balance sheets described in 10 and 11 and the arrangements with the government to secure its financial strength have been made public.

1

Helpful comments were provided by Simon Gray, Karl Habermeier, Christopher Towe and participants at a Monetary and Capital Markets Department seminar at the IMF, and by Eugenio Gaiotti and other participants at an European Central Bank Workshop. Simon Townsend provided excellent research assistance.

2

For histories of central banking, see Goodhart (1988), De Kock (1974), and Bagehot (1878).

3

The de jure obligation of governments to recapitalize central banks varies considerably (Lonnberg and Stella, 2008).

4

Several other taxonomies have been employed. Balance sheet policies have been divided into those that increase the size of the balance sheet and those that alter its composition (e.g., Bernanke and others, 2004). Balance sheet policies have also commonly been sorted into quantitative easing (QE), usually referring the purchase of long-term securities by the central bank, and credit easing (CE), or support for credit markets (cf Bernanke, 2009a and Lenza and others, 2010). However, these terms are not used consistently. QE bond purchases can be for the financial stability objective of boosting secondary market liquidity or for the macroeconomic goal of reducing long-term interest rates. Similarly, CE has been used to refer to support for financial stability objectives (e.g., to boost liquidity in an important secondary credit market) and to more direct support to borrowers (e.g., central bank lending to corporations). Borio and Disyatat (2009) employ another taxonomy of exchange rate policy, quasi-debt management policy, credit policy, and bank reserves policy. Finally, the taxonomy employed here may not square with how central banks described their own balance sheet policies.

5

The term “funding markets” refers here to short-term money markets in which financial institutions trade bank reserves (e.g., interbank markets, repo markets), while the term “credit markets” denotes financial markets in which not only financial institutions but also non-financial enterprises issue debt instruments, such as commercial paper, corporate bonds, and asset backed securities.

6

For example, the Fed introduced its 1-month term auction facility (TAF) in December 2007 and extended the tenor to three-months in August 2008, while the maturity of its repo operations in normal time was two-week at maximum. The ECB, which had regularly conducted 1-week and 3-month refinancing operations, extended the maturity to 6 months in April 2008 and to 12 months in June 2009.

7

The MBS/GSE debt purchases by the Fed initially announced on November 25, 2008 (about three weeks before the policy rate was reduced to effective zero) can be judged as intended to ameliorate the stress in MBS/GSE debt markets for financial stability purposes.

8

According to Bernanke (2010a), “Generally, the Federal Reserve lent at rates above the ‘normal’ rate for the market but lower than the rate prevailing in distressed and illiquid markets.”

9

In making this distinction, Calvo (2006) takes the view that foreign exchange liquidity support follows from an information advantage of the central bank which allows it to identify risks, which give reason to circumvent a dysfunctional foreign exchange market and provide liquidity to systemically important institutions. In late 2008, foreign exchange markets in a number of countries ceased to function because banks were hoarding foreign exchange (Baba and packer, 2009).

10

Foreign exchange liquidity support is more difficult to measure compared to other balance sheet policies because many central banks do not report foreign exchange swap data and don’t report foreign exchange sales aimed at liquidity easing.

11

The theoretical model of Martins and Salles (2010) has segmented domestic and foreign exchange markets makes central bank foreign exchange liquidity provision out of foreign reserves effective.

12

Foreign exchange swaps (the sale of foreign exchange with a commitment to buy back from the counterparty at a specified date and exchange rate) may be preferable to intervention in the spot market because the latter can be interpreted as meant to influence the exchange rate.

13

The central bank of Brazil provided collateralized US$ financing via auction to financial institutions, who on-lent to exporters, and targeted Brazilian corporations with US$ loan payments falling due over a pre-specified period.

14

When swap arrangements between the Fed and four central banks was reactivated in May 2010, the Fed clarified the modalities of the price setting of U.S. dollar provision by foreign central banks as follows: “The loans provided by the foreign central banks to institutions abroad are offered at rates that would be above market rates in normal times. As such, when market conditions are not greatly strained, demand for dollar liquidity through the swap lines should not be high, as market alternatives would be more attractive.” (Tarullo 2010).

15

This paper does not address the unconventional non-balance sheet monetary policy of committing to maintaining low interest rates for an extended period to boost aggregate demand, as was done by the Bank of Japan in the late 1990s and more recently by the BoC. See also Bernanke and others (2004) and Clouse and others (2000). The BoJ also made a commitment to keep its quantitative easing policy in the early 2000s (Oda and Ueda, 2007).

16

They hark back to pre-Bretton Woods days when financial markets did not function as well. During the 1950s and 1960s, monetary policy analysis focused on portfolio substitution effects arising from imperfect substitutability between different assets (Tobin, 1958; Friedman, 1956).

17

In this paper, the term “bond purchases” is shorthand for the central bank purchase of long-term public securities for macroeconomic objectives. These are different from purchases aimed at injecting liquidity into stressed government bond markets, as undertaken recently by the ECB with its Securities Market Programme. The discussion about bond purchases applies to purchases of mortgage backed securities (MBS) and Agency debts by the Fed as they are guaranteed or issued by government-sponsored agencies, although they also have some elements of liquidity support to credit markets (especially the initial purchases in late 2008) as well as central bank involvement in credit provision to the extent that they are targeted to a specific sector.

18

Mechanically, bond purchases to banks involve the central bank receiving the securities while increasing bank reserves—increasing both sides of the central bank and bank balance sheets and shifting asset duration to the central bank. Purchases of bonds from non-bank investors involves the investor transferring the security to its bank in exchange for cash deposits (keeping the size of the investor balance sheet unchanged and shortening the duration of its assets), while the bank transfers the securities to the central bank in exchange for reserves at the central bank, again increasing both sides of the central bank and bank balance sheets.

19

An extreme case is the Fed during 1942–51 when it maintained ceilings on Treasury yields at seven maturities (Toma, 1992).

20

Bond purchases have also been viewed as operating through a bank reserve channel whereby banks would lend out the cash they received for their long-term securities. For example, in 2000, the BoJ targeted a fixed level of bank reserves, suggesting that it expected transmission to go via bank balance sheets. More recently, the BoE also stressed the reserve liquidity enhancement channel. However, the reserve channel explanation of bond purchase transmission has come to be less emphasized by central banks. The model of Cúrdia and Woodford (2010) suggests that central bank asset purchases do not work through the reserve channel.

21

Bond purchases, or other macroeconomic stability balance sheet policies, could also work by signaling a discrete break of the central bank from past cautious policies. This may have been the case when the Roosevelt administration adopted effective new expansionary policies in 1933 (Romer, 1992). This channel is not focused on here.

22

Gagnon and others (2010) emphasize the amount of duration that is taken out of the stock of long-term securities available to investors. For example, the $300 billion in completed Treasury purchases as of January 2010 was equal to $169 billion 10-year equivalents. According to them, the more duration taken out of markets, the less risk faced by investors, and the lower the risk premium.

23

Monetary theory has long disregarded the role of the central bank’s balance sheet (cf Kohn, 2009). Many traditional models used for monetary policy analysis abstract altogether from the central bank’s balance sheet by simply treating a short-term nominal rate as the sole control variable for the central bank’s monetary policy operations (Cúrdia and Woodford, 2010). This follows Wallace (1981)’s “irrelevancy result” that both the size and the composition of the central bank balance sheet should not matter for market equilibrium in frictionless financial markets—more precisely, (i) assets are valued only for their pecuniary returns and (ii) all investors can purchase arbitrary quantities of the same assets at the same prices.

24

See the minutes of the Federal Open Market Committee (FOMC) for the September 21, 2010 meeting.

25

Bernanke (2010b) and King (2010) discuss exit strategies.

26

Bernanke and others (2004) review the earlier literature on the effectiveness of bond purchases.

27

The impact of interest rate changes on the central bank balance sheet depends on the adjustment of the yield curve, the exit strategy and accounting procedures (Appendix II).

28

Svensson (2001) proposed large-scale foreign exchange intervention in support of a fixed exchange rate as a way to overcome the lower interest rate bound.

29

In the late 1970s, the Swiss National Bank undertook large purchases of foreign exchange during a temporarily shift to a fixed exchange rate target prompted by a rapid appreciation (Kugler and Rich, 1992).

30

In 2008, SNB recorded a net loss of 0.9 percent of GDP due to valuation losses of foreign reserves. Among other central banks, the ECB made a net loss of 1.6 billion euro or 0.02 percent of GDP due to valuation losses of foreign reserves in 2004.

31

Indeed, in some models of unconventional monetary policy (e.g., Gertler and Karadi, 2009) the central bank has explicit fiscal powers.

32

In command economies and many developing economies, gaps arising from the absence or incompleteness of markets led to a variety of roles for central banks in financial intermediation (Chandavarkar, 1996; Fry, 1993; Mackenzie and Stella (1996)). Central banks continue to play a financial development role in some countries (Alegieuno, 2008).

33

For example, in its 1987 Annual Report the Banco de Portugal reported that interest rate subsidies were the equivalent of some 50 percent of its reported profits.

34

Individual central banks have presented implicit or explicit “principles” regarding aspects of balance sheet policies (Bank of Canada, 2009; Tucker, 2009; Bank of Japan, 2009).

35

Angeloni and Faia (2010) model different policy mix exit scenarios.

36

Reinhart and Sbrancia (2011) document how governments during the late 1940s to the 1970s reduced debt by various means of “financial repression”, some of which involved central banks.

37

Kohn (2009) argued that the risk that the interest rates expenses of the Fed would outweigh the interest earnings from long-term securities is unlikely.

38

Bean (2009) suggests that BoE initiated the Quantitative Easing to achieve the Bank’s macroeconomic objectives—hitting the inflation target without generating undue volatility in output--, while acknowledging the program could have certain impacts on public financing costs.

39

The estimate of the U.S. figure after “QE2” requires assumptions on (i) the list of the securities the Fed will purchase by June 2011 and (ii) the base line list of outstanding government securities in 2011. For (i), the Fed is assumed to purchase the government securities in line with the maturity composition disclosed at the website of the Federal Reserve Bank of New York (http://www.newyorkfed.org/markets/opolicy/operating_policy_101103.html). For (ii), the U.S. Federal debt held by the public is assumed to be 69.3 percent of GDP in 2011 based on Celasun and Keim (2010)

40

We exclude the effect of “QE1” which comprised $1.25 trillion of GSE-backed MBS, $175 billion of GSE debts, and $300 billion of U.S. Treasury for the following reasons: first, including GSE-related securities, in particular GSE-backed securities which consist of claims on private debtors and contingent claim on GSEs, would extremely complicate the computation. Second, as the Fed holdings of treasury securities after the “QE1” was almost the same level as pre-crisis, it would not be appropriate to argue that the Fed’s crisis-response measures including “QE1” shortened the maturity of the public sector debt.

41

See Code of Good Practices on Transparency in Monetary and Financial Policies, principles 1.2 and 1.3 Guidelines for Public Debt Management, Summary of the Debt management Guidelines, Section 1.3 coordination with monetary and fiscal policies.

42

See “Minutes of the Federal Open Market Committee March 17-18, 2009.”

43

See “Minutes of the Federal Open Market Committee April 27-28, 2010.”

44

For detailed discussion, see Peter Stella (2008).

Should Unconventional Balance Sheet Policies Be Added to the Central Bank toolkit? a Review of the Experience so Far
Author: Kotaro Ishi, Mr. Kenji Fujita, and Mr. Mark R. Stone