Daniela Gabor is a professor of economics and macrofinance at the University of West of England, Bristol. In this post, focusing on the ECB example, she explains why now might be a good time for central banks to abandon many of their market-discipline focused measures like margin calls and haircuts.
The Corona crisis reminds us that the market-mechanism-based lender-of-last-resort system is not fit for purpose. Central banks’ dependency on market valuations and haircuts is intended to maintain market discipline. In reality the mechanism potentially exacerbates the very same pressures extraordinary action is supposed to be countering.
Take the European Central Bank’s emergency dollar loans to its banking system as one example.
On March 20, the central banks of the world’s largest financial systems – the US Federal Reserve, the Bank of England, the European Central Bank, the Bank of Japan, the Swiss National Bank and the Bank of Canada (C6) – announced that they would update the emergency provision of US dollars via central bank swaps. To do so they offered seven-day dollar-denominated repo loans on a daily basis starting March 23, in addition to weekly loans of 84-days maturity.
The take-up was as follows (data courtesy of Dan Hinge).
While the ECB’s exposures are small compared to what they were in 2008, especially relative to other central banks like the BoJ, they still run the risk of inducing potentially systemic implications. This is because, like many other central banks, the ECB monitors and margins loans on a daily basis which can, in volatile times, undermine their effectiveness if not add to market pressures.
European banks need dollar financing for their dollar assets (loans, bonds, derivative positions etc) or for their clients. Usually, in non-crisis times, they get dollars from dollar repo markets, other wholesale funding markets or from FX swap markets. In crisis times, willingness to provide dollar funding shrinks in private markets. Some European banks can borrow directly from US Federal Reserve, but most are dependent on the ECB.
The Fed’s swap line agreement with the ECB is a matter of mutual interest: the US Fed wants to preserve the integrity and resilience of the US dollar as international reserve currency while the ECB wants to preserve the stability of its financial system.
In the first leg of the swap, central banks ‘lend’ each other their own currency. The ECB has a dollar deposit account with the Fed, and that account gets credited with the agreed sum, at an agreed exchange rate and for an agreed period. The ECB pays interest, and also creates euro facility for the Fed’s account at the ECB.
If exchange rates fluctuate for the duration of the central bank swap, the central bank whose exchange rate depreciates has to pay the other in what is known as a margin call. The IMF has a good explainer of how this works. These periodic margin calls cover the difference between actual and agreed exchange rates, which creates credit risk between the two central banks. Margins are kept in a separate account and returned when the swap unwinds. If central banks expect the US dollar to appreciate, they may prefer to draw down on their US dollar reserves first, before tapping the Fed. So far, only the ECB has drawn on the swap lines, with $45bn outstanding on March 18.
How does the ECB ‘lend’ the US dollars it has in its Fed deposit? It lends US dollars to European banks every week, in three-month repo loans against collateral. To access these loans, banks have to provide collateral securities denominated in either euros or dollars.
The repo loan has a peculiar accounting and legal treatment: it is structured as a sale and repurchase (hence repo) contract. Private banks ‘sell’ collateral to the ECB and promise to repurchase it in 84 days time. The ECB prefers this arrangement – widespread in Europe – because it gets legal title to the underlying collateral and can sell it if the private bank defaults.
The devil, as usual, is in the valuation that the ECB applies to the collateral. The mechanism has three components.
The FX haircut
The ECB asks for a 12 per cent FX haircut to protect itself against foreign currency risk. That means for every $100, it requires banks to give $120 of collateral – either in dollar- or euro-denominated securities or cash (reserves) – at market value. Think of haircuts as safety cushions that protect the parties from adverse movements in the exchange rate.
Since the haircut hikes the costs of dollar funding, it is also intended to prompt European banks to return to private dollar funding markets as soon as possible. It is, in other words, punitive.
FX-related margin calls
But exchange rates can fluctuate by more than 12 per cent in a period of three months. To protect itself further, therefore, the ECB has decided to update the euro value of the dollar loan every eight days. If the dollar appreciates, the ECB makes a margin call: it asks banks to ‘update’ their collateral position to the new exchange rate by sending in more collateral (and vice-versa for the euro appreciation).
These sorts of FX-related margin calls on banks amplify banks’ dollar funding pressures. If the bank cannot meet this margin call, it may be forced to sell dollar or euro assets. This pro-cyclical aspect of the ECB’s dollar-repo collateral framework makes the long-term USD loan equivalent – in terms of funding pressure – to a seven-day repo . Of course, these may need renewing at that day’s exchange rate, but allow banks more freedom to adjust their balance sheets in response to any drastic FX market moves.
Collateral-related margin calls
For any repo loan, the ECB marks collateral to market on a daily basis. If securities fall in price, the ECB asks the bank to make up for the difference (another margin call). The daily variation margin is intended to protect the ECB against the risk that the counterparty defaults or if it needs to sell the collateral.
In sum, the ECB’s dollar-denominated repo loans have three important moving components: the FX-related haircut, the weekly margin calls on FX movements for loans longer than seven days and the daily margin calls on euro/dollar collateral. This hardwires pro-cyclicality into the facilities, i.e. exposes the positions to further deterioration as markets move in exactly the direction the facilities were introduced to ameliorate. Only the daily auctions at seven-day maturities moderate one point of pro-cyclical pressure by allowing banks more flexibility in adjusting their balance sheet in response to the pressures of dollar appreciation.
This poses an important question: why does the ECB, a lender of last resort, need protection against collateral/FX risk?
The quick answer is that the collateral valuation regime is there to ensure that when the borrower defaults, the repo lender can sell the collateral securities it legally owns and recover its cash. Daily valuation is meant to keep the market value of those securities equal to the cash lent. But daily margining can induce the sort of liquidity spirals that turned the collapse of Lehman Brothers in 2008 into a globally systemic event.
We already know, the ECB’s collateral regime on its long-term repo loans threatened to do the same during the sovereign debt crisis, until Mario Draghi promised to do “whatever it takes”. This action alone helped to preserve the liquidity of (Italian) sovereign bond collateral, and with it, the integrity of the Eurozone repo funding markets.
Christine Lagarde, the president of the ECB, reiterated that promise in a recent FT ‘whatever it takes’ submission. But if central banks are there to protect liquidity, as she argues, then calling margin on its banks in the name of market discipline or moral hazard is too blunt a tool.
Lagarde should consider going further. The current collateral valuation regime is only a recent invention. As can be seen below, before the euro was introduced, none of the Eurosystem central banks marked collateral to market or made daily margin calls.
Now would be a good time to return to that regime.
It’s good to see the ECB may already be getting the message. The Governing Council has mandated central bankers around the currency area to investigate collateral easing measures in relation to some of its offers of cheap central bank funds.
What we need at this juncture is a step away from market-based protection of central bank balance sheets, and a step towards true loss absorbing capacity.