vol. 5, no. 4 MaY 2010­­ EconomicLetter Insights from the F e d e r a l r eserve Bank o F d a l l a s The Term Auction Facility’s Effectiveness in the Financial Crisis of 2007–09 by Tao Wu In the second half of 2007, financial turmoil swept over the U.s. and The TAF and other other major economies. Triggered by a subprime mortgage meltdown, the crisis lending facilities quickly spread to other major financial markets and precipitated the worst eco- established during the nomic downturn since the Great depression. although financial and economic crisis were an conditions have improved substantially, the wrenching episode’s effects are still experiment that with us. proved effective in during the crisis, financial markets experienced tremendous strains, addressing severe and the cost of short-term funding rose sharply. The gap between the three- financial turbulence. month unsecured london interbank offered rate (libor) and the overnight in- dexed swap (oIs) rate is frequently used as a measure of tensions in interbank money markets. as the crisis began in early august, this spread jumped from less than 0.1 percentage point to almost 1 percentage point within a month. at the crisis’s peak in september 2008—just after the collapse of lehman Brothers and the rescue of American Interna- lending market’s breakdown rendered tional Group—the gap soared to an those tools inadequate for addressing unprecedented 3.7 percentage points. the unusual financial market pressures The spikes in the Libor–OIS gap during this crisis. testify to the severity of a crisis that Open-market operations are the posed serious challenges to central Fed’s most powerful and frequently banks around the world. In response, used policy tool, providing overnight several of them created new lending credits at the federal funds rate. Every To find out whether the facilities to quickly provide liquidity day, the Fed trades on the open mar- to the banking sector and improve ket with a select group of primary liquidity facilities have market functioning. The list includes dealers, directly buying or selling the European Central Bank, Bank of Treasury or government agency securi- been working as England, Bank of Canada and Swiss ties or repurchase agreements against National Bank. On Dec. 12, 2007, the such securities. intended, it’s important Federal Reserve established its ver- In normal times, primary deal- sion—the term auction facility (TAF). ers distribute the liquidity increases to to understand the Researchers have yet to reach other financial institutions through the a consensus on the effectiveness of interbank money market, increasing nature of the heightened such facilities. This Economic Letter, the flow of credit to the overall econo- based on a recent study, provides an my. In turbulent times, however, finan- strains on interbank econometric evaluation of whether the cial institutions are reluctant to lend to TAF helped relieve strains in the U.S. each other, and the channel can clog. money markets. money market.1 The findings reveal The discount window gives the that the TAF has reduced liquidity risk Fed an alternative means of adding premiums paid by banks; however, it liquidity. Depository institutions in has been less effective in cutting coun- sound condition can obtain fully col- terparty risk premiums. lateralized overnight loans at an inter- est rate that’s usually higher than the The Financial Crisis federal funds rate. The subprime mortgage market’s From 2003 to the summer of 2007, growing problems began to draw the discount rate had been 100 basis attention in early 2007. However, it points above the federal funds target. took several months for the financial After the initial jump in money-market crisis to spread to money markets. On interest rates, the Fed narrowed the Aug. 9, 2007, French investment bank discount rate premium to 50 basis BNP Paribas halted redemptions from points on Aug. 17, 2007, and to 25 three of its subsidiary mutual funds, basis points on March 17, 2008. The and in response, overnight interest terms of discount window loans were rates shot up in Europe and the U.S. extended to up to 30 days in August The interbank money market 2007 and later to 90 days. The Fed is the main gateway for commercial also made the loans renewable at the banks to quickly obtain funding to request of the borrowers. make loans. Deteriorating condi- These measures were taken to tions greatly impaired the stability of encourage banks to use the discount this critical short-term funding and window, but the effects were modest posed severe challenges to central due to the so-called stigma problem. banks’ ability to provide ample liquid- During a financial crisis, banks may be ity through regular monetary policy reluctant to borrow from the discount channels. window because of concerns that Under normal circumstances, the markets would interpret it as a sign of Fed injects liquidity into the economy financial weakness. The stigma might by two means—conducting open-mar- damage their reputations, lower their ket operations and lending at the dis- market values and reduce their ability count window. However, the interbank to borrow in the market. EconomicLetter 2 Federal reserve Bank oF dallas Federal reserve Bank oF dallas EconomicLetter As strains in money markets persisted and worsened in early Chart 1 December 2007, the Fed established a new lending alternative—the term Libor–OIS Spread Widens in 2008, Raising Doubts auction facility. Through this facil- About TAF ity, the Fed auctioned preannounced amounts of credit, twice a month, Percentage points, annualized to eligible depository institutions in 4.5 Failure of G7 action, sound financial condition for a term of Lehman Lehman CDS 4 2 Brothers; AIG settlement one month instead of overnight. The (Sept. 15–16) (Oct. 10) 3.5 TAF accepted the same kinds of collat- TAF eral as the discount window. established 3 (Dec. 12) The TAF was initially set at $20 Bear Stearns 2.5 billion for each auction. It was gradual- bailout (Mar. 17) ly increased to $150 billion in January 2 2009 before it was scaled back. The 1.5 final auction was held March 8, 2010. After the TAF’s establishment, 1 credit conditions in the interbank .5 market improved significantly. The three-month Libor spread over the OIS 0 2006 2007 2008 2009 rate dropped sharply from more than 1 percentage point in early December SOURCE: Haver Analytics. 2007 to less than 0.3 percentage point in late January 2008 (Chart 1). However, the spread widened again to sheets is likely to become more costly of the price per unit of risk and the about 0.8 percentage point in spring and harder to obtain. Fund managers perceived amount of risk—should also 2008. may also demand that extra liquidity decline. As macroeconomic and financial be readily available to cover potential The final channel entailed offering market conditions worsened substan- redemptions.4 other readily available funding sources tially in the second half of 2008, the Through lending facilities to pro- to discourage banks from excessively spread jumped. The upswing and the vide credit to financial institutions in hoarding liquidity purely out of indi- later surge in Libor spreads raised need, the Fed and other central banks vidual precautionary concerns. doubts about the new liquidity facil- sought to relieve financial strains These channels provided reason ity’s effectiveness.3 through several channels. to believe the TAF and other liquidity To find out whether a liquid- The first and most direct channel facilities might alleviate financial strains ity facility is working as intended, it’s involved providing additional funding in the interbank money market. important to understand the nature of to banks in immediate need of liquid- the heightened strains on interbank ity, lowering short-term borrowing Quantifying TAF’s Effects money markets. During financial stress, costs.5 Money market strains come from banks become increasingly reluctant to The second channel focused on both the larger demand for liquidity lend to each other for two reasons. reducing the pressure on banks to during a financial crisis and heightened First, counterparty risk—the pos- liquidate assets, helping counteract counterparty risk. I first examine the sibility that the institution on the other upward pressure on banks’ funding TAF’s effect by addressing these two side of the transaction may default— costs from deterioration in money mar- concerns separately, and then quantify increases with the uncertainty about ket conditions. All else equal, this may the TAF’s overall effect. banks’ financial conditions. contribute to a decline in counterparty Reducing liquidity premiums. Second, banks tend to build up risk. I focus on examining the TAF’s effect precautionary liquidity to guard against The third channel centered on in relieving banks’ liquidity concerns mounting uncertainty about the mar- strengthening confidence so that inves- by controlling for the variation in sys- ket value of their assets—for instance, tors would demand less compensation tematic counterparty risk premiums. various structured credit products. In for a given unit of risk—i.e., the price Because measures of these premiums times of financial stress, funding to of risk may decline in the TAF’s pres- aren’t readily available, I construct one keep these assets on banks’ balance ence. The risk premium—the product based on the observed credit default EconomicLetter Federal reserve Bank oF dallas Federal reserve Bank oF dallas 3 EconomicLetter dollar Libor survey and use it as a Chart 2 proxy for the major banks’ systematic default risk premiums. Credit Default Swap Premiums Gyrate During Crisis Chart 2 displays this systematic counterparty risk factor along with the Percentage points, annualized individual CDS rates of several major 5 banks included in the Libor survey.