Stabilising financial markets: Lending and market making as a last resort

Starting with the 2007-2009 crisis and continuing with the Covid-19 pandemic, financial markets have faced a series of adverse liquidity shocks. As a result, central banks expanded their policy frameworks as enhanced lenders of last resort and market makers of last resort. This column summarises the key features of these expanded policy toolkits and how they have been used to protect financial stability. It also outlines a set of desirable features of these facilities to maximise effectiveness while minimising risks in the future.

Market liquidity disappears when there are no willing buyers, or when the only bids are at prices far below any reasonable estimate of fundamental or fair value. This can happen when the normal purchasers of the instrument vanish or when the market makers malfunction. Starting with the 2007-09 financial crisis and continuing through the Covid-19 pandemic, financial markets faced a series of adverse shocks that severely impacted liquidity. In response, central banks scrambled to update their policy toolkits as enhanced lender of last resort (LOLR) and as market maker of last resort (MMLR) (Buiter and Sibert 2007, Cecchetti and Tucker 2021). To ensure financial stability, safeguard the monetary policy transmission mechanism, and guarantee the continued flow of credit to the real economy, central banks expanded their lending operations to restore funding liquidity and intervened in financial markets directly, purchasing securities to restore market liquidity.

Looking at the actions of 40 central banks for the period from March 2020 to March 2021, Cantú et al. (2021) catalogue 527 interest rate changes, 59 adjustments in reserve requirements and reserve remuneration rates, 143 lending support actions, 101 actions related to exchange rate policy (including swap lines), and 54 asset purchase operations. Advanced economy central banks are clearly less hesitant now to intervene in a variety of markets than they once were. These interventions were on an ad hoc basis. ¹

After all, without well-functioning financial markets and a stable financial system, the monetary policy transmission mechanism would not function properly, and policymakers would not be able to meet their price stability or dual mandates. Rising policy rates aimed at restoring price stability, combined with high public and private sector debt, raises the risk that market liquidity and funding liquidity for systemically important financial instruments and market participants could suddenly disappear once again.

In a recent report of the Advisory Scientific Committee of the European System Risk Board (Buiter et al. 2023), we discuss the implications of lending and market making as a last resort to stabilise systemically important financial markets.

In their traditional lending operations, central banks make loans to banks and a limited range of other intermediaries against a restricted set of high-quality collateral. Today, a much wider range of collateral is accepted from a broader range of eligible counterparties in enhanced lending operations directed at ensuring credit flows to non-bank financial institutions (NBFIs) and non-financial firms. Furthermore, the experience following the 2007-09 financial crisis shows that central banks’ enhanced lending to impaired market makers has often succeeded in restoring their market making capacity, obviating the need for direct purchases. While a credible announcement of a market maker of last resort facility could suffice to stabilize markets without the need for any asset purchases, on a number of occasions central banks (or entities they controlled) acquired bonds outright and expanded their lending operations, both within and across borders.

Source :- Voxeu