1 Studi e Note di Economia, Anno XIV, n , pagg GruppoMontepaschi Emergency Liquidity Assistance at work: both words and deeds matter* MICHELE MANNA** Emergency Liquidity Assistance (ELA) is a central banks function as old as these institutions can be. It is also a very modern instrument, as proved by some recent events. The ambition of this paper is first to outline some models of central banks communication on ELA; second to redress some common places about what Bagehot would have written on this topic in his Lombard Street; th.rd to review the decisions enacted by policy makers in the banking crises of Sweden (early 1990s), United Kingdom (1995), United States (2001) Austria (2006) and again United Kingdom and United States ( ). Overall, the main message we can gather is that if crisis management is about (re)building trust in financial markets, neither in its words nor in its deeds the central bank should be perceived as hesitant. (J.E.L.: E42, E58, G21, N31, N33) almost two hundred years after Thornton, the lender-of-last resort function remains an art not a science, to be applied on a case-by-case basis. Giannini (1999) I. Introduction Emergency Liquidity Assistance (ELA) to financial firms in distress is a central banks function as old as these institutions can be, to judge from the fact that its classic and ever-green foundations were laid down by Thornton in 1802 and Bagehot in his 1873 Lombard Street book. Such an honourable history does not call the case closed on ELA and, in the midst of the market turbulence originated in 2007 in the US subprime credit segment, prominent central bank Governors felt appropriate to restate their views on emergency refinancing and on the lesson by Bagehot 1. Arguably, issues such as the role of the instrument in crisis management or the balance between transparency in its communication and grip on moral hazard remain part of the debate on *Paper accepted in september ** Bank of Italy. My thanks are due to C.O. Gelsomino, who was the source for much food-for-thought on the topic of ELA, R. De Bonis, P. Maggio, C. Mastropasqua, S. Nobili, F. Panetta and the participants to an internal Bank of Italy seminar for helpful comments. I am also indebted to R. Potito for a number of editorial suggestions. The views expressed here are the sole responsibility of the author and do not necessarily reflect those of Bank of Italy. 1 Consider e.g. the speeches given by B. Bernanke, Chairman of the US Fed, on 13 May 2008 and G. Stevens, Governor of the Reserve Bank of Australia, on 15 April 2008.
2 156 Studi e Note di Economia, Anno XIV, n central banking. The ambition of this paper is to journey through the topic of ELA by dealing with both theoretical and practical issues. To do so, the paper will revolve around four questions: 1. What is ELA? 2. How central banks communicate on ELA? 3. Which conditions may be applied on the emergency assistance? 4. How do central banks actually intervene in financial crises? The first question could seem a trivial one basic intuition identifies ELA as central bank credit granted in emergency situations, as suggested by the acronym if it were not the case that doubts linger on whether ELA is anything different from ordinary monetary policy operations. On a different ground, the emergency condition may be a necessary though not a sufficient one if, say, the Fed s loosening of its liquidity supply on the aftermath of September 11 th is usually reckoned more a form of lending to the market than, strictly speaking, ELA. If ELA is part of the armoury of a central bank, as most analysts would agree, this institution cannot escape the problem of how best to craft its communication on the instrument. A survey over the Statutes, Acts and other official documents of 18 central bank helps to identify some basic models of communication, ranging from near silence to formal open statements. The answer to the second question is complemented by an analysis of a number of recent memoranda of understanding on crisis management. Because these documents are less constrained by legalistic language, they offer good examples of how central banks communicate their intended strategies on crisis management and thus on the extraordinary refinancing. Dealing with the third question almost unavoidably implies touching base on the triplet associated to the name of Bagehot, namely that at times of crisis the central bank ought to lend (i) at a high rate of interest, (ii) on good banking securities and (iii) freely. In fact, a reading of the original work by this author suggests more nuances than this would-be dictum suggests. Goodhart (1999) is a sure reference on how to dissect the accretion of myths from shallow readings of Lombard Street. So much about the words on ELA. The fourth question looks at the related deeds. Here, I follow a business case approach by reviewing the actions taken within the management of some recent financial crises. The focus will be on the crises of Sweden in the early 1990s, United Kingdom in 1995 (Barings), United States in 2001 (after September 11 th ), Austria in 2006 and again United Kingdom and United States in (Northern Rock and Bear Stearns). By way of introduction, I should also define the boundaries of the present work and clarify a terminological element. With a view to striking a middle point between breadth and depth of the research, the list of questions I proposed above is not exhaustive and, say, other relevant topics include the international domain of the lender of last resort (Giannini, 1999, and Jeanne and
3 M. Manna - Emergency Liquidity Assistance at work: both words and deeds matter 157 Wyplosz, 2001) and the stress testing activity (Sorge, 2004). Furthermore, this is not one more survey on ELA. Not because writing a survey is less relevant, but because excellent ones are already available (Freixas et al., 2000, is among my favourites). I should also state my preference for using in this paper the term emergency liquidity assistance (ELA) vs. lender of last resort (LOLR). The two terms are often used interchangeably, although they may carry different nuances as the latter is perceived as broader in scope. Let us give here the floor to two central banks, Bank of Canada and Sveriges Riksbank, whose official publications featured an article on the lender of last resort, as made it clear in the title 2. In both cases, the article covers a number of issues relating to the role of the central bank in financial crisis management; however, within each of the two articles, the section referring to the provision of emergency credit by the central bank turns to the term emergency liquidity assistance. Accordingly, I will mainly speak of ELA since the paper chiefly deals with the act of providing liquidity under emergency. This notwithstanding, in citing the literature I will feel free to switch to LOLR if this is the term used by the author and by which her/his work is more often remembered, to avoid distracting the reader with non-substantive elements of notational content. The rest of the paper is organised as follows. Second II to V try to answer to each of the questions outlined above, while in section VI some concluding remarks are put forward. II. What is ELA A basic issue a paper like this should try to address relates to what is ELA in the first place. In terms of the mechanics of the operation, ELA is about granting credit to a financial counterpart, typically a bank, under exceptional circumstances and usually against collateral. Most of these qualifications could equally apply to an ordinary central bank open market operation. For sure, the nature of the counterpart and the request for collateral are not peculiar. I will also argue below that the level of the applied rate of interest is not necessarily a discriminating element in recognising an ELA. Thus, one should not be surprised if some authors do not recognize the emergency lending as a separate central bank tool, since any liquidity provision to the market falls, in their judgement, within the broad spectrum of open market operations. Arguably, a noticeable feature of ELA relates to the extraordinary circumstances prevailing when the refinancing takes place, circumstances which apply to the financial firm receiving the assistance (and not necessarily to the market as a whole). 2 Bank of Canada (2004): Bank of Canada Lender-of-Last-Resort Policies ; Sveriges Riksbank (2003): The Riksbank s role as lender of last resort.
4 158 Studi e Note di Economia, Anno XIV, n This firm may be troubled by an IT or other technically-related failure which prevents its ordinary trading in the interbank market. The accident occurred at the Bank of New York in 1985 (a computer failure) proves that this is not academic theory; this being acknowledged, the instance of an ELA in response to a liquidity crisis triggered by an outage is a bit of a rarity. More common seems to be a scenario where some (non-technical) shock leads to heightened uncertainty and more risk averse attitudes. If information about the value of banks assets were freely available, market participants would be able to fully conduct peer monitoring and there should be nothing like an illiquid but solvent bank, because the latter condition (solvency) would ensure the access to the interbank credit and thus remove the former (illiquidity). In fact, information is often incomplete and costly and this is likely to be even more so during financial crises. To play safe, market participants curtail their credit lines, without much discriminating between counterparts actually affected by the shock and those that have no direct link with the firm setting off the crisis. Under these circumstances, even if liquidity supply is adequate at an aggregate level, some banks could no longer manage to borrow enough funds even though in principle they would be creditworthy. As a result, their reserve account with the central bank heads toward negative territory, unless they receive an additional cash injection. Hence, in an ELA operation, we observe an ad hoc cash injection which is targeted by the central bank specifically towards the bank(s) in need, so that a more general increase in the aggregated liquidity supply would not necessarily be the right cure to subdue the crisis (although it may help) 3. From this, one could gauge that the so-called lending to the market, i.e. when the central bank opts for keeping liquidity supply unusually ample in response to some major event, is not ELA. This is exactly because the central bank goal is to increase the overall supply, and not to modify its distribution at a micro level 4. As in many areas of the debate on public intervention, views are split over whether the authority is better placed than market participants to selectively aid illiquid banks. In a well-known paper, Goodfriend and King (1988) conclude that there is little evidence that public lending to particular institutions is either necessary or appropriate, a view upheld also in Kaufman (1996). Their basic argument is that the central bank should be content with regulating the aggregate liquidity supply, leaving to banks the subsequent distribution of funds as a way to enhance peer monitoring. On a different line of thinking, supporters of free banking theories dispute the need for a central bank and thus, a fortiori, for discretionary forms of interventions. The expe- 3 A formal model that caters for illiquid but solvent banks is in Rochet and Vives (2004), a model of the lender of last resort in the context of a payment system crisis is in Flannery (1996). 4 This paper will cover however also the Fed response to September 11th, as an example of liquidity management in a crisis situation,
5 M. Manna - Emergency Liquidity Assistance at work: both words and deeds matter 159 riences of free banking in Scotland from 1792 to 1844 and Canada throughout the nineteenth century are generally rated as rather positive, although the extent to which these were fully free banking systems remains up to debate; a short summary of these two experiences is presented in annex. However, on the whole, the consensus is skeptical on the possibility that a banking systems may prove to be financially stable over a lengthy period without some authority ready to provide ad hoc external funding when circumstances warrant. That is, some public authority must provide the lender of last resort (Bordo, 1989). The consensus view builds on two basic arguments. First, it is as a fact of life that embattled banks do receive some type of support more often than not. In a survey over 104 banking crises occurred mostly in the 1980s and 1990s over 24 developed countries, Goodhart and Shoenmaker (1995) count 81 instances were some form of external funding was made available to failing banks and only 23 instances of no funding 5. Second, on a more theoretical level, the argument à la Goodfriend and King requires perfect repo and unsecured interbank markets (Freixas et al., 2004). In fact, in the aftermath of a shock the information advantage enjoyed by the monetary authority visà-vis ordinary participants is reckoned, if anything, to be widening. Furthermore, while the former weighs the cost of the selective lending (think to the moral hazard) against the benefit of reducing the likelihood of a systemic crisis, the latter is concerned with the financial risk-return profile of the deal at stake. As a result, even if the central bank and the single market participant availed of the same (limited) information set, the ensuing decision taken by these two pehes may turn out be different. III. When the central bank utters the E L A words Communication in this field could be a misnomer if a lender of last resort should exist, but his presence should be doubted (Kindleberger, 1978). As implicitly suggested by this quote, one option for central banks in designing their communication on ELA is not mentioning the issue altogether. By saying as little as possible on the conditions to receive the emergency lending, the illiquid bank will naturally tend to consider first better-known sources to tap its demand for funds and, hopefully, it will eventually turn to the central bank for ELA only when no alternative is in sight. Alternatively, the central bank can explicitly state its readiness to provide ELA when appropriate, although usually a number of caveats are embedded in the statement. 5 It is fair to acknowledge though that, from the viewpoint of an advocate of free banking, the banking system would find in itself the remedies to the crisis, with no need for external support, if there were no central bank in the first place. A survey of the so-called fiscal costs of a number of financial crises is in Dziobek and Pazarbasiogolu (1997).
6 160 Studi e Note di Economia, Anno XIV, n Before proceeding further, it is honest to acknowledge that the gulf between the alternative policy options of near-silence and open disclosure could be narrower than it looks at first sight. As will be argued below, the preference for setting out public guidelines on emergency refinancing probably owes more to earlier interventions on the occasion of a crisis, which make less meaningful the point of being (almost) silent, rather than to theoretical differences on the best communication policy (Sveriges Riksbank, 2003). References to ELA in the law, the Statute and other official documents of central banks A survey of publicly available documents issued by 18 central banks returns three benchmark models of communication on ELA: - in six central banks (Austria, France, Greece, Italy 6, Luxembourg and Germany), few or no explicit references about ELA can be in found in their Statute or other legislative texts, nor many utterances have been made by the Governor and other members of the Board 7 ; - in four central banks (Belgium 8, Finland 9, Ireland 10 and Switzerland 11 ), the Statute includes a reference to the duties of the central bank towards preserving financial stability, while a more explicit acknowledgement of its potential recourse to ELA can be found in other documents published by the central bank; in the case of the Netherlands the latter statement only applies 12 ; 6 In its Financial Sector Assessment Program on Italy of 2006, the IMF staff states: Although financial institutions may request emergency liquidity assistance (ELA) from the BI [Bank of Italy], they have not availed themselves of this option since the establishment of a new institutional framework in 1999, pursuant to the establishment of the ESCB (page 15; the document is available at 7 The validity of this statement is confined to the speeches to which I had access browsing the central banks websites. 8 Statutes of the National Bank of Belgium, art. 23 (1): The Bank shall contribute to the stability of the financial systems. In its website, this central bank adds: The National Bank holds a key position as the lender of last resort. 9 Act on Bank of Finland, art. 3: The Bank of Finland shall also.. participate on maintaining the reliability and efficiency of the payment system and overall financial system. In its website, the Bank Finland states: The Bank of Finland aims at maintaining confidence in the financial system without having to intervene. The Bank may, however, assume a more active role if the smooth functioning of the financial system is threatened. The last example of the Bank s intervention was in the early 1900s, during Finland s business crisis. 10 Central Bank and Financial Services Authority of Ireland Act 2003, art. 5(b): the objective of the Bank in contributing to the stability of the State s financial system. In its website this central bank clarifies: The Bank s responsibility to contribute to the overall stability of the financial system also involves:.. iv. Undertaking official financial operations in exceptional circumstances. 11 Swiss National Bank Act, art. 5 (2)(e): [the National Bank] shall contribute to the stability of the financial system. Swiss National Bank (2006) clarifies further that the SNB also acts as lender of last resort. In this function, it can provide emergency liquidity assistance for one or more domestic banks. 12 The Bank Act 1998 of De Nederlandsche Bank does not include explicit references to ELA / lending of last resort. In a speech given in 1992, Governor Wellink elaborating on Central Banks as guardians of financial stability emphasised that Central banks have always been involved in trying to preserve financial stability, for instance through their role as lender of last resort.
7 M. Manna - Emergency Liquidity Assistance at work: both words and deeds matter in further six central banks (Japan 13, Norway 14, Portugal 15, United Kingdom 16, Sweden 17 and the United States 18 ), explicit references to the ELA / LOLR can be found in the Statute and other official documents. In between the first and the second group of central banks, one could classify the Banco de España whose Statute explicitly foresees duties in the field of financial stability, but it does not further detail whether this could actually imply the offer of ELA, nor this can easily be inferred from other official documents relating to this central bank 19. If an open stance on the subject is a viable option, as the survey suggests it is more common than often acknowledged, it should be of some interest to look more closely at the precautions taken to control for the risk of moral hazard. Let us follow here two central banks that have been particularly transparent on the subject. Bank of Canada (2004) sets out a clear guideline: the Bank provides ELA only to institutions judged to be solvent. It also acknowledges however that there may be contingencies which, though unlikely, cannot be dismissed altogether and call for a different line of action: In the extremely unlikely event of the failure of more than one LVTS [Large Value Transfer System] participant on the same day... the Bank could be obliged to lend to a failed institution, on a partially unsecured basis, to ensure settlement of the LVTS and so protect against systemic risk. One could thus understand that, if the worse comes to the worst, the central bank would no longer necessari- 13 The Bank of Japan Law, art. 37.1: The Bank of Japan.. may provide uncollateralized loans to financial institutions.. and other financial business entities prescribed by a cabinet Order.. when they unexpectedly experience a temporary shortage of funds for payment due to accidental causes. The following art. 38.1: The Prime Minister and the Minister of Finance may request that the Bank of Japan to conduct the business necessary to maintain an orderly financial system, including provision of loans, when it is believed to be especially necessary for the maintenance of an orderly financial system. 14 Act of Bank of Norway, art. 19 (3): when warranted by special circumstances, the Bank may grant credit on special terms. 15 Banco de Portugal, Organic Law, art. 12: it shall be particularly incumbent upon the Bank to:.. c) Provide for the stability of the national financial system, performing, for the purpose, in particular, the function of lender of last resort. 16 Memorandum of Understanding between HM Treasury, the Bank of England and the Financial Services Authority, art. 14: In exceptional circumstances, there may be a need for an operation which goes beyond the Bank s published framework for operations in the money market. Such a support operation is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance in the UK economy Sveriges Riksbank Act, Chapter 6, art. 8: In exceptional circumstances, the Riksbank may, with the aim of supporting liquidity, grant credits or provide guarantees on special terms to banking institutions and Swedish companies subject to the supervision of the Financial Supervisory Authority. 18 Federal Reserve Act, Section 10A Emergency Advances to Groups of Member Banks, art. 1 ( Authority of Reserve Banks to Make Advances ): any Federal reserve bank may make advances.. to groups of five or more member banks within its district.. provided the bank or banks which receive the proceeds of such advances as herein provided have no adequate amounts of eligible and acceptable assets available to enable such bank or banks to obtain sufficient credit accommodations from the Federal reserve through rediscounts or advances other than as provided in section 10b. 19 Again, this statement is applicable only to the documents I browsed, i.e. in effect those available on the website of the Banco de España.
8 162 Studi e Note di Economia, Anno XIV, n ly abide by the principle of illiquid but insolvent and its practical equivalent of full guarantee. As to the potential recipient of the credit, these are ordinarily (if this is the right word in the context of a financial crisis) identified in the banks; however, Under extreme conditions, the Bank can provide liquidity to any firm. A somewhat similar path is followed in Sveriges Riksbank (2003): To avoid the unnecessary retention of inefficient banks and distorting bank behaviour, the Riksbank should not support banks that lack long-term survival capacity 20 (emphasis in the original text). At the same time, it is almost unavoidable that the tendency to refrain from granting liquidity assistance declines where systemic risk is substantial, even if the assessment of the institution s ability to pay is uncertain. As to the recipients, while It is primarily if a bank suffers liquidity problems that the Riksbank has reason to intervene, it is also the case that other companies than banks can give rise to contagion risks in the financial system, thus suggesting that the extraordinary support could be extended to other financial firms. The age of memoranda A remarkable feature of the nouvelle vague on the communication on crisis management is the signature of a Memorandum of Understanding (MoU) by the authorities entrusted with maintaining financial stability. All the consulted MoUs seem to lack the binding power of a law or even of a contract; they define however a commitment and as such they may be regarded as a piece of soft law (Goodhart and Shoenmaker, 2006). Details on thirteen MoUs are reported in Table 2, summary statistics in Table 1. Overall, they distribute evenly both along the domestic/cross border dimension and according to the nature of signatory parties: (i) central banks; (ii) central banks and banking supervisory authorities; (iii) central banks, banking supervisory authorities and ministries of finance. Four main elements recur in such documents. First, the MoU sets out the responsibilities of the involved parties in respect to financial stability and, notably, crisis management. In doing so, as a rule, most if not all the key elements of the resulting outline are already defined, more or less explicitly, in the applicable legal framework. This is not meant to say that this section of the MoU is a trivial copy-and-paste: in fact, there is an effort in presenting the roles of the authorities in a plain, non-legalistic language. One could thus infer that, in effect, by signing a MoU the authorities mean to speak to an audience broader than the one versed in documents such as central banks statutes. Note that the text of the large majority (9 out of 13) of the consult- 20 Sveriges Riksbank (2003) clarifies that it is not sufficient that the value of assets is greater than the liabilities (given a fair evaluation) for an institution to be solvent. It is also necessary that the bank has the capacity to generate profits.
9 Tab. 1 - Consulted memoranda of understanding in the field of financial stability Place of Signatory authorities Public status Date of issuance Link application (1) Australia The Reserve Bank of Australia and the Australian Prudential full text available October Regulatory Authority ra_mou.pdf (2) Belgium and the National Bank of Belgium, Belgian Banking, Finance Press release June Netherlands and Insurance Commission and De Nederlandsche Bank 1_00_00/ _memorandum_of_understanding.htm?t=ho&l=en (3) Denmark National Bank of Denmark and Finanstilynet (Danish Banking full text available December Supervisory Authority) _ /$File/MoU_DN_FT_dec06.pdf (4) Denmark National Bank of Denmark, Danish Ministry of Finance full text available April and Danish Ministry of Economic and Business Affairs _financial_supervision_april05/$file/memorandum_uk.pdf (5) Estonia, Latvia, Central Banks of Estonia, Latvia, Lithuania and Sweden full text available December Lithuania _est_lat_lit_swe.pdf and Sweden (6) European nordic Central banks of Denmark, Finland, Iceland, full text available June Norway and Sweden countries U_eng0603/$File/MoU_eng.pdf (7) European Union Banking supervisors and central banks of the European Union Press release March (8) European Union (a) Banking supervisors, central banks and finance ministries Press release May 2005 (a) of the European Union (9) Finland Bank of Finland and Financial SupervisionAuthority reference March in the website oytakirjat.htm (10) Ireland Central Bank & Financial Services Authority of Ireland full text available October and Irish Financial Services Regulatory Authority (11) The Netherlands De Nederlandsche Bank and Minister of Finance full text available February ive/news_2007/en/ html (12) Sweden Ministry of Finance, Sveriges Riksbank and Finansinspektionen full text available June radsdok_kris_eng_0602.pdf (13) United Kingdom HM Treasury, the Bank of England and the full text available March 2006 (update) Financial Services Authority (a) On 4 April 2008, a new Memorandum of Understanding on co-operation between the Financial Supervisory Authorities, Central Banks and Finance Ministries of the European Union on cross-border financial stability was agreed. A detailed introduction is available at: _Releases/April/0404ECOFIN_Memorandum.html.
10 164 Studi e Note di Economia, Anno XIV, n Tab. 2 - Summary statistics on the consulted MoUs. Domestic Cross-border total Central banks only Central banks and banking supervisory authorities Central banks, banking supervisory authorities and ministries of finance (treasuries) total ed MoUs is publicly available; where this is not the case, a sufficiently detailed press release has been issued. Furthermore, given the subject of this paper, it is highly relevant that an explicit reference to ELA can be found in six of the nine MoUs whose text is public and no MoU rules out this form of support. Second, the bulk of the MoU deals with improving the cooperation and the exchange of information among the signing parties notably when a crisis breaks out. Because of this, substantial attention is devoted to aspects of coordination and some crisis management committee is established. To avoid that such committee becomes rusty in the interval of time between one crisis and the next, regular gatherings are convened: on a monthly basis in the UK, at least quarterly in Sweden, periodically (with no defined frequency at least as far the text of the MoU goes) in the Netherlands, at least once a year in Denmark, monthly or more frequently in Australia. By contrast and perhaps surprisingly, no such need for regular gatherings is mentioned in the international MoUs. Third, the MoU outlines the conditions under which the procedures laid down in the MoU itself should be activated. The crisis situation is described in fairly general terms 21. But one element that clearly emerges is that it holds a system s dimension. 21 if either the RBA [the Reserve Bank of Australia] or APRA [the Australian Prudential Regulation Authority] identifies a situation which it considers is likely to threaten the stability of the financial system, it will inform the other as a matter of urgency (Australian MoU); if the financial situation within a financial enterprise or in a financial market is deemed to entail significant risks to financial stability, the issue shall be discussed by the Coordination Committee (Danish MoU). 22 By way of example, consider the MoU signed by the central banks of the European Nordic countries: The responsibility for managing a financial crisis in a bank rests primarily with its owners and management.. Thus, emergency liquidity assistance from the central banks will only be provided in exceptional circumstances, while the Danish MoU states: the four parties to the agreement shall seek to find solutions whereby owners of base capital and the board and management themselves bear the responsibility to the greatest possible extent. Likewise, the press release announcing the 2005 EU MoU states that: The memorandum of understanding should not be construed as representing an exception to (i) the principle of the firm s owners / shareholders primary financial responsibility, (ii) the need for creditor vigilance, and (iii) the primacy of marketled solutions to solve a crisis situation in individual institutions.