The Federal Reserve is set to announce as early as on Wednesday a fundamental overhaul of the way it provides liquidity in financial markets in a bid to tackle head-on severe strains in the interbank money market.
The US central bank is expected to unveil a new liquidity facility through which it will auction loans to a large number of financial institutions, accepting a broad range of securities as collateral in return.
The move reflects a realisation among top Fed officials that their existing tools - open market operations and direct discount window loans - are having little effect on painfully high rates in the market for term interbank loans.
These are loans made by one bank to another for periods of up to a few months. The Fed is able to control the overnight federal funds rate by pumping in liquidity through open market operations.
However, the money is not flowing from the overnight market into the term interbank markets. Only a small number of primary dealers can access money directly from the Fed through open market operations. These financial institutions appear reluctant to lend the money on to other banks, in part because they do not want to expand their own balance sheets, and in part because they are worried about the creditworthiness of their counterparties.
Moreover, the open market desk is prohibited from accepting most mortgage securities as collateral. A large number of banks can in principle borrow directly from the Fed through the discount window against a wider range of collateral. But in a recent speech Don Kohn, vice-chairman, said the market "stigma" of borrowing from the Fed was preventing the discount window from serving its proper function as a backstop to market liquidity.
As a result, most mortgage lenders are turning to the Federal Home Loan Banks rather than the Federal Reserve as a lender of last resort. The new Fed plan aims to change that. The precise details of the new facility are not known. But it is loosely modelled on a 2000 Fed working paper that proposed creating a facility that would auction credit to banks.
This came at the time when the US central bank worried that the US government might repay all its debt, eliminating the market for Treasury securities through which the Fed conducts open market operations.
Fed officials have dusted down this proposal and adapted it to address the current credit market crisis. Vincent Reinhart, a fellow at the American Enterprise Institute and former chief monetary economist at the Fed, says this kind of auction facility would allow the Fed to provide funds directly to a much larger group of banks than the limited number of primary dealers who participate in open market operations, against a wide range of collateral, without the stigma of the discount window.
"I think it would be very positive," he says. Banks in need of liquidity could acquire funds relatively anonymously, while the large number of participants with direct access to Fed money would encourage arbitrage to exploit the gap between cheap Fed money and high interbank rates.
Moreover, the Fed could auction funds at whatever term it wanted to in order to target liquidity at particular term markets - for instance, the market for one-month loans. It would have the option of either auctioning a fixed amount of funds, or offering to supply whatever funds were needed at a target rate.
The intended interest rate spread over the Fed funds rate is not known. If the Fed decided to auction loans at or only slightly above the Federal funds rate, it would risk subsidising weaker banks, which normally pay a premium to borrow in the interbank market. However, Mr Reinhart says this could be dealt with by varying the amount of collateral required in return for loans based on the creditworthiness of the bank seeking funds.
The US central bank is expected to unveil a new liquidity facility through which it will auction loans to a large number of financial institutions, accepting a broad range of securities as collateral in return.
The move reflects a realisation among top Fed officials that their existing tools - open market operations and direct discount window loans - are having little effect on painfully high rates in the market for term interbank loans.
These are loans made by one bank to another for periods of up to a few months. The Fed is able to control the overnight federal funds rate by pumping in liquidity through open market operations.
However, the money is not flowing from the overnight market into the term interbank markets. Only a small number of primary dealers can access money directly from the Fed through open market operations. These financial institutions appear reluctant to lend the money on to other banks, in part because they do not want to expand their own balance sheets, and in part because they are worried about the creditworthiness of their counterparties.
Moreover, the open market desk is prohibited from accepting most mortgage securities as collateral. A large number of banks can in principle borrow directly from the Fed through the discount window against a wider range of collateral. But in a recent speech Don Kohn, vice-chairman, said the market "stigma" of borrowing from the Fed was preventing the discount window from serving its proper function as a backstop to market liquidity.
As a result, most mortgage lenders are turning to the Federal Home Loan Banks rather than the Federal Reserve as a lender of last resort. The new Fed plan aims to change that. The precise details of the new facility are not known. But it is loosely modelled on a 2000 Fed working paper that proposed creating a facility that would auction credit to banks.
This came at the time when the US central bank worried that the US government might repay all its debt, eliminating the market for Treasury securities through which the Fed conducts open market operations.
Fed officials have dusted down this proposal and adapted it to address the current credit market crisis. Vincent Reinhart, a fellow at the American Enterprise Institute and former chief monetary economist at the Fed, says this kind of auction facility would allow the Fed to provide funds directly to a much larger group of banks than the limited number of primary dealers who participate in open market operations, against a wide range of collateral, without the stigma of the discount window.
"I think it would be very positive," he says. Banks in need of liquidity could acquire funds relatively anonymously, while the large number of participants with direct access to Fed money would encourage arbitrage to exploit the gap between cheap Fed money and high interbank rates.
Moreover, the Fed could auction funds at whatever term it wanted to in order to target liquidity at particular term markets - for instance, the market for one-month loans. It would have the option of either auctioning a fixed amount of funds, or offering to supply whatever funds were needed at a target rate.
The intended interest rate spread over the Fed funds rate is not known. If the Fed decided to auction loans at or only slightly above the Federal funds rate, it would risk subsidising weaker banks, which normally pay a premium to borrow in the interbank market. However, Mr Reinhart says this could be dealt with by varying the amount of collateral required in return for loans based on the creditworthiness of the bank seeking funds.
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