Given that traditional central bank lending tools were insufficient to resolve the recent COVID-inspired ‘dash for cash’, there may be a need for new tools to tackle core market dysfunction in response to how markets are changing, according to the Financial Stability Board.
Releasing its latest report, Assessing the resilience of market-based finance, the FSB – which was established in the wake of the 2007/8 financial crisis – said that the growth of non-banks as key intermediaries and providers of finance to the real economy, and the constraints that traditional central bank counterparties face during stress, mean that there is a growing chance of tail-risk liquidity events within financial markets to which central banks will feel compelled to respond.
It added that formalising the terms and conditions on which liquidity will be available in advance can help set expectations among market participants about the circumstances in which central banks will, and will not, act:
“In considering the design of such tools, central banks will need to ensure that they will be effective in resolving dysfunction particularly given there could be scenarios where resort to using monetary policy tools such as QE would not be appropriate given the monetary policy stance.”
“More generally, central banks will need to ensure that these tools act as a backstop; that the risks to the central bank balance sheet can be managed; and that they do not result in negative side effects such as perverse incentives to take risks.”
The FSB suggested that one potential option to enhance the central bank toolkit could be to amend the terms and parameters of central bank lending/repo operations such that they directly or indirectly provide liquidity against high-quality sovereign debt to a broader range of counterparties such as non-banks.
It added that a key policy question to consider would be which entities might be eligible for access to such a facility. As such, it suggested, in order for the tool to be fully effective it would need to be available to a broad enough set of firms to capture those with significant presence in the core market in question.
However, the FSB conceded, there may be a risk that a formal central bank backstop encourages greater leverage among these participants: “Therefore, as with central bank lending, the official sector will need to consider whether and how such moral hazard can be avoided, including through regulation and design parameters such as pricing and haircuts.”
The FSB analysis also showed that one of the legacies of COVID-19 crisis may be a build-up of leverage and debt overhang in the non-financial sector.
High corporate, as well as in some cases, levels of sovereign debt, were already a concern before the outbreak of the pandemic, but addressing debt should be a key task:
“Rapid and large credit support has increased debt levels, especially in the hardest-hit sectors. Addressing debt overhang, including by facilitating the market exit of unviable companies, and by promoting the efficient reallocation of resources to viable firms, may be a key task for policymakers going forward.”
Follow us on twitter: @RisksEmerging