The Clearing House today published a staff working paper “Recognizing the Value of the Central Bank as a Liquidity Backstop.” The paper argues that a critical missing element of the internationally agreed bank liquidity condition metric, the liquidity coverage ratio (LCR), is recognition of the liquidity support available from the central bank. The paper describes how the Fed could combine a regular discount window lending facility that charges a bank a high interest rate with a deposit facility that pays a somewhat lower interest rate in a manner that would result in the bank getting recognition under the LCR of its borrowing capacity, for a fee. Likely inadvertently, such arrangements effectively already exist at the ECB, BoE, and BoJ. If the Federal Reserve were to adopt the proposed facilities, it would create a more level playing field for U.S. banks, enhance economic growth, make the financial system safer, and raise money for taxpayers.
Banks of all sizes, today and in the past, establish borrowing capacity at Federal Reserve by filing the necessary paperwork and pledging collateral to the discount window. A bank that has made such preparations is better able to meet future liquidity needs than one that hasn’t, but the LCR does not recognize this improved liquidity.
The paper notes that, in addition to providing a more accurate measure of banks’ liquidity situation by affirming the liquidity value of having collateral pledged to the Fed’s discount window, creating the proposed facilities would have seven significant benefits:
- It would allow the Fed to charge banks a commercially appropriate fee for back-up liquidity support, thereby ensuring appropriate incentives for its provision;
- It would promote economic growth by improving the liquidity position of banks, thereby enabling them to lend more to businesses and households and less to the government, both in ordinary times and in crises;
- It would help better align the U.S. LCR to international norms, ensuring a more level playing field for U.S. banks relative to foreign banks;
- It would increase the usability of the HQLA that banks hold to meet their LCR, reducing the need for banks to hold liquidity buffers on top of the required LCR buffer;
- It would provide the Fed a tool to limit liquidity transformation in the shadow banking system, promoting financial stability;
- It would strengthen the ability of the Fed to respond to a financial crisis; and
- It would facilitate the conduct of monetary policy.
The facilities would entail virtually no risk for taxpayers — loans would be significantly overcollateralized and the Fed has never lost a dime on a discount window loan. Moreover, the arrangements would require no changes to the existing LCR regulation or to the law.