On December 12, the U.S. Federal Reserve, the European Central Bank, and three other major central banks announced they would work together to try to relieve stress on credit markets. Roger M. Kubarych, CFR’s adjunct senior fellow for international economics and finance, says the initiative should restore confidence because it “dramatically reduces the fear that some big bank out there is going to fail.” He adds, however, that banks have greater concerns than their reserve requirements, most notably that they now hold large quantities of misvalued loans: “The real issue is not reserve management, but the valuation of all these loans.”
Last week, a number of central banks announced they would take coordinated measures to try to increase liquidity for banks and, hopefully, stabilize credit markets. First, I was hoping you could explain what all they’re planning.
What we have seen in many countries is quite an unusual demand for excess reserves.* In the U.S., for instance, we’ve brought down required reserves dramatically over the years, for a variety of reasons, most particularly because large institutional clients of banks—major corporations and so on—have been able to use technology to greatly reduce the uninvested balances they leave in a regular checking account. A major company like Dupont or IBM would be able to reduce their balances that don’t earn interest drastically—almost to zero. As a result, the Fed used to put pretty high reserve requirements on demand deposits [money held by banks that can be withdrawn at any time without notice, such as funds held in checking accounts], and not much on anything else. But once the big players don’t have much in the way of demand deposits, the amount of reserves that are required are very tiny.
So all the headlines you’ve been reading in the last several months are about banks’ demands for excess reserves. Now why would they want to hold excess reserves at the Fed? [The new regulations call for banks to hold some excess reserves at the Fed that can be auctioned off to other banks in case of emergency.] The answer is, as a precaution. A precaution against not being able to fund themselves on an intraday basis—over the course of a day having to come up with additional reserves as part of the ebb and flow of securities transactions, and other transactions. For a big bank, those can add up to over a trillion dollars a day. And also because they need funding for various lending operations that they’re doing.
This coordinated effort by the central banks is designed to deal with what you might call the psychological reality that no big bank wants to go to the discount windows of their various central banks for loans. There’s a huge stigma attached. If it gets out—and it almost certainly does get out in some countries—that might be viewed, particularly by the stock market, as a sign of severe weakness. We had a case in England in the summer of a mortgage specialist, Northern Rock, having a real run—just like in the 1930s B movies. It’s proved to be very good for the central banks to be able to do things in a coordinated way. As an announcement effect, it worked well. And the actual mechanics of what they’re going to do are very sound. They’re going to imitate something like a discount-window collateral requirement, but with an auction process that makes it much less obvious who is bidding for funds and why.
This level of coordination is fairly unusual, no?
It’s unusual but it’s not unprecedented.
Does it tell us much about the way central banks are looking at credit markets at this point? Does the fact that they’re coordinating now mean that they’re taking a more dire view of the market than they were a few months ago?
They are at least equally dire as they were in August. There was some improvement, particularly after the Fed [U.S. Federal Reserve] cut the federal funds rate by fifty basis points in September, leading to a pretty good rally in the stock markets. But in November things really came apart at the seams again, and this is a reaction to that flare-up of tensions.
How big of an intervention is this? Is it still fairly limited at this point?
It depends what you mean by limited. All of these numbers are small relative to the size of the banking system. The total size of the U.S. commercial banking sector was $10.9 trillion, at the end of the third quarter. The total amount of reserves at the Federal Reserve, of the entire commercial banking industry, is $20 billion. So look at that: $10.9 trillion versus $20 billion. So the reserves that they need to put up at the Fed are really tiny. This is where the journalism is really an obstacle to understanding. Essentially the banking system does not normally need very many reserves at the Fed. So all of these programs are confidence-building exercises—what you might call cosmetic exercises on the part of the banks. The real issue is how many of the securities they have created and held are worth anything close to what they’re listed at on the balance sheet. We’ve seen enormous losses by a number of banks, aggregating much more than the $20 billion in reserves. That shows you that the real issue is not reserve management, but the valuation of all these loans.
What the Fed is going to provide from these auctions of reserves is $40 billion. These are tone-of-voice-type numbers—if you say it in a loud enough voice, journalists think that’s a lot of money. But next to the size of the total assets of the banking system, it’s very small.
Do you think it’s likely to succeed in its goal of restoring confidence?
Yes, because it dramatically reduces the fear that some big bank out there is going to fail. That’s an absolutely crucial thing to do. Most years you wouldn’t even think of saying that this is an issue. But this year, when you have all these losses—and it’s not just in the commercial banks; you’ve had something like one hundred of these mortgage banks fail, the biggest being New Century last winter, and these massive losses taken by hedge funds during the summer—you can see that this is really an exceptional crisis. But the way the Fed is going to do this, is very imitative of the way the European central banks have been doing it all along, running these auctions. That allows those banks to bid anonymously for funds which will then be made available against collateral. And that collateral will be the same collateral that was accepted at the discount window, but it won’t have the stigma of the discount window. So to me it’s a win-win situation. The banks win because they get increased excess reserves without it raising a threat of being identified as being in trouble, so they don’t get the stigma. And the Fed can honestly say, well, if nobody comes to the auction, it means everyone’s fine.
You’re sounding fairly positive on this specific move. How do you assess the Fed’s performance over the last year?
They’re going to have to do a lot of self-assessment. All you have to do is go back to various speeches and statements that officials have made, and they have to go, “Why did I say what I said about the situation back in February or April or May.” There were some infelicitous statements about the true contours of the mortgage-market mess. They were inconsistent. Many people outside the Fed were raising concerns that the Fed was essentially pooh-poohing. So they have to do a lot of soul-searching about why they were pooh-poohing it. Was it bad analysis? Was it bad data? Were they just trying to smooth things over by knowing things were worse and not saying so? Is that a good strategy when the truth comes out? They’re the ones who are going to have to assess their performance.
What are the policy implications here of the credit squeeze more broadly? Obviously, nobody’s really arguing for much stronger regulations on what kinds of securitization happens, but people are talking about having to regulate securities better. What needs to happen?
The SEC [Securities and Exchange Commission] has got a big job of self-evaluation as well. There are a lot of culprits here. The place I want to see the SEC place more emphasis is on the oversight of rating agencies, and their appropriateness in this kind of business. The rating agencies have years of experience rating the bonds of individual corporations. They have hardly any experience rating collateralized debt obligations that include brand new instruments like credit default swaps, alongside various kinds of mortgages, now called subprime, usually called unconventional, which had no history under stress. And they were giving ratings on them. They’ve got institutions that bought these things on the basis of ratings that they themselves should have known had hardly any statistical basis. They’ve got some soul-searching, too. So I can’t think of anyone who comes out of this looking too well, other than a few people who shorted the whole thing.
Is the Treasury among them, the folks that aren’t looking too good now?
The fundamental problem is that there are a lot of people with mortgages they can’t afford. And the president of the United States made a statement the first week of September saying we’re going to do something for those people. And then his administration did not follow through. Only recently has the secretary of the treasury put [a plan] together—what I would call just dipping a toe in the water—to do something that will help the tens of thousands, maybe hundreds of thousands of people, to deal with the fact that they were seduced or attracted to mortgage instruments that they didn’t understand and really couldn’t afford. So this is a national tragedy. And the policy from the administration doesn’t live up to President Bush’s own demand that they do something. That’s not good, and it requires a considerable amount of self-assessment. But what’s been proposed so far from the Treasury is totally inadequate to the problem.
* A reserve requirement determines the percentage of a bank’s total holdings it is legally required to keep on hand. Excess reserves, which are any cash holdings over the reserve requirement, are thought uneconomical because they do not earn interest. Banks typically try to minimize their excess reserve holdings by using them to make short-term loans to other banks.