03 Mar 2023

Financial stability as a precondition for monetary policy

U.S. economist Stephen Cecchetti argued in a SAFE-CEPR RPN Policy Web seminar for conditions under which central banks operate as lenders or market makers of last resort

Central bank intervention in financial markets through direct or indirect bond purchases is controversial because it does not directly contribute to the central bank mandates. In both the financial crisis of 2007 to 2009 and the Corona crisis, central banks expanded their facility, i.e., their lending capacity, to maintain market liquidity. In times of crisis, this is definitely important, Stephen Cecchetti said. Without stable financial markets, effective monetary policy is not possible, explained the Professor of International Finance at Brandeis University in the United States in a web seminar on 21 February 2023. 

In the joint event organized by the Leibniz Institute SAFE and the Centre for Economic Policy Research European Finance Architecture Research Policy Network, Cecchetti presented ten desirable conditions under which central banks should act as lenders of last resort (LOLR) or market makers of last resort (MMLR). Together with Willem Buiter, Kathryn Dominguez, and Antonio Sánchez Serrano, he published these conditions in a January report of the European Systemic Risk Board’s (ESRB) Advisory Scientific Committee. Afterward, researchers Frank Keane of the Federal Reserve of New York and Darrell Duffie of Stanford University commented on the proposals by Cecchetti and his co-authors. The event was moderated by Loriana Pelizzon, Director of SAFE’s Financial Markets Research Department.

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“Without functioning financial markets, monetary policy does not exist,” Checchetti argued, pointing to the case of the Bank of England, the United Kingdom’s central bank, which likely averted a financial market crisis in Great Britain by intervening in the U.K. government bond market in October 2022 with a total volume of 65 billion pounds. According to Cecchetti, central bank operations as LOLR or MMLR is justified to stabilize systemically important financial markets. This, he said, is also a condition to support the real economy.

During the Corona pandemic, numerous of these interventions were observed around the world, in varying magnitudes. Banks expanded the securities and counterparties they accepted, thus Cecchetti referred to enhanced LOLR. As with traditional LOLR, he said, there are haircuts on collateral quality, and counterparties are accepted that are regulated and supervised. As with the traditional LOLR function, there would be haircuts on collateral quality, and counterparties that are regulated and supervised would be accepted.

Hurdles in the pricing of securities

As market makers central banks buy and sell securities directly in illiquid, systemically important markets. Finding the right price is difficult: it must be above the market price to be unattractive in normal times but should be below the underlying value of the securities, Cecchetti explained. In order to do so, central banks should make sure that collateral prices are constantly reviewed and that transactions do not affect the monetary base, thus central bank money. 

Cecchetti prefers central banks as LOLR: “In the context of lending, private actors determine prices, and we also have experience in dealing with moral hazard consequences,” he said. Frank Keane, who works with Darrell Duffie on research on public purchase programs, agreed with Cecchetti that the LOLR function is the preferred solution. “But that will not be enough to address market failures,” he argued, “it is best to prepare on all fronts.” Keane particularly emphasized the difficulty of setting the right penalty rates. Especially with a standing facility, that would be a challenge. The policy rate could only serve as a benchmark, he said. 

Conclusively, the researchers dicussed potential moral hazards. These would have to be addressed in normal times. On the one hand, this would require extended congruent regulation across borders. On the other hand, market structures would have to be improved, for example through more central clearing. “When you are in the middle of a financial crisis, it is too late to deal with moral hazards, by letting the markets even more unstable,” Duffie emphasized. The ensuing discussion clearly showed the complexity and importance of discussing and setting a frame for these facilities in times of financial stability.