Looking for Liquidity -- Banking and Emergency Liquidity Facilities

24 Pages Posted: 11 Feb 2016

Date Written: February 9, 2016

Abstract

As lender of last resort, the Bank of Canada has the responsibility of stepping in to provide liquidity in cases when markets require emergency funding. In crisis situations, a timely and effective response is imperative for avoiding systemic breakdowns. In this Commentary, I argue that in order to achieve this goal, a predefined, permanent, market-wide emergency liquidity mechanism should be established. The benefits of such a mechanism, including on-going design improvement and transparency for market participants, outweigh concerns over the moral hazard it may generate. The financial crisis of 2008-09 led to a new set of reforms through the Basel III regulatory framework. These rules have provided stability, including by limiting risky behaviour by financial institutions. However, they have also created a significantly smaller market for liquidity. Therefore, in future times of stress, financial institutions will face increased difficulty obtaining funding from private markets. Furthermore, as technologies become more sophisticated, idiosyncratic shocks can propagate into systemic shocks faster than ever before. Combined, these concerns suggest the need for pre-established, non-discretionary, market-wide emergency liquidity facilities that are instantly available in times of crisis. The permanence of such facilities would allow the design to be improved as market conditions evolve, while the removal of discretion would increase the level of transparency that is vital for a well-functioning financial sector. While the design of the emergency liquidity features introduced by the Bank of Canada during the 2008- 09 global economic crisis was appropriate, the auction format used likely fell short of generating the competitive prices and quantities that create both optimal liquidity distribution and the highest possible return for the public. In this paper, I recommend the use of the “Product-Mix” auction design, which involves an unlimited bid, single-round process in which bids are made on different forms of collateral simultaneously, and no minimum reference price above the benchmark overnight rate is established in advance. The Bank should continue to use discriminatory pricing for different term repos and uniform pricing for term loan facilities. Overall, these characteristics should improve the outcome of any future auctions from the viewpoint of both financial institutions and central bankers.

Keywords: Financial Services, Economic Growth and Innovation

JEL Classification: E58, G20, G21

Suggested Citation

Kronick, Jeremy, Looking for Liquidity -- Banking and Emergency Liquidity Facilities (February 9, 2016). C.D. Howe Institute Commentary 445, Available at SSRN: https://ssrn.com/abstract=2730098 or http://dx.doi.org/10.2139/ssrn.2730098

Jeremy Kronick (Contact Author)

C.D. Howe Institute ( email )

67 Yonge St., Suite 300
Toronto, Ontario M5E 1J8
Canada

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