Thursday, March 31, 2011

The FDR Framework and Disclosure of Discount Window Borrowing: Part II

A Bloomberg article explains how the Fed has traditionally acted as a gatekeeper of useful, relevant information on the financial institutions it regulates and is being dragged kicking and screaming to disclose this data.
For most of its 98-year history, the Federal Reserve has operated with all the transparency and enthusiasm for change of the Vatican. Now the ultra-secretive Fed is starting to change its ways, if somewhat grudgingly. Some of the new openness, such as Chairman Ben S. Bernanke’s plan for quarterly press briefings, is the central bank’s idea. Much of it comes under duress. 
Today, the Fed is set to disclose which banks borrowed from its discount window during the darkest moments of the 2008-09 financial crisis... Still, the Fed won’t disclose the collateral it accepted, which would reveal the risks it took.
Please note that disclosure of discount window borrowings does not negatively impact the central bank's role as lender of last resort.  As was pointed out in an earlier post on the FDR Framework and disclosure of discount window borrowing:
if the market was provided all the current asset and liability-level data under the FDR Framework, it would know which banks were borrowing at the discount window because they were insolvent waiting to be resolved and which banks were borrowing at the discount window that were solvent and had a temporary funding issue.
One of the features of the FDR Framework is that it shows exactly what collateral a central bank lends against.  As Walter Bagehot recommended a century ago, central banks are suppose to only lend against good collateral.  With disclosure under the FDR Framework, the market can see if this is true or not.

The article then makes the case for disclosure.
... Given the prominent role the world’s biggest banks played in causing financial losses worldwide, largely because of what investors didn’t know or didn’t understand, some say the loans should be made public at once, ... Only then, the reasoning goes, would investors and counterparties of a Fed borrower be able to manage their own risks. “The free-market system only works if it’s fully informed,” says Lynn E. Turner, who battled the Fed over disclosure issues while serving as the Securities and Exchange Commission’s chief accountant from 1998 to 2001. “There’s a lot of similarity between the Fed and an SUV with blacked-out windows.”
The article continues by laying out the Fed's justification for not disclosing information.
The Fed says such calls threaten its core function: preserving market confidence by acting as a lender of last resort. Publicizing the names of discount-window borrowers could spark bank runs or discourage sick banks from seeking help until they are fatally compromised. “The full monty may not be a good thing,” says Frederic Mishkin, a former Fed governor. 
For the Fed, keeping information from investors is nothing new... 
The discount window is the Fed’s oldest lending channel and traditionally its most secretive. Banks have been free to use it without publicly revealing the fact since the Fed’s 1913 birth... 
Some former Fed insiders say the public should routinely be clued in when private institutions tap the public purse, in the same way the SEC requires companies to inform investors of major financial events. “This should be material information. Investors should have the right to know,” says Roberto Perli, a former Fed board economist who is managing director of International Strategy & Investment in Washington.

Banks traditionally have been reluctant to use the window, fearing that savvy investors could tell by following clues in Fed loan data and market activity...
This justification is fundamentally wrong.

  • Market confidence is undermined when the market does not know what is happening.  As the article points out, how are counterparties suppose to manage their own risk?
  • As pointed out above, disclosure does not interfere with the Fed's lender of last resort role.  What would interfere is if the borrower runs out of good collateral to pledge.
  • As pointed out in numerous posts on this site (see here for a list), disclosing current asset and liability-level data like discount window borrowing actually prevents bank runs.  With all the useful, relevant information disclosed, market participants can distinguish between solvent and insolvent discount window borrowers.  The Fed's current policy contributes to financial market instability and sparks bank runs.  In the absence of information, when rumor leaks out that a bank is borrowing at the discount window, depositors and investors have an incentive to engage on a run on the bank to get their money back because they do not know if the borrowing was a sign of insolvency or not. 
  • The reluctance to borrow from the Fed's discount window will disappear with disclosure of current asset and liability-level data.  Since the markets are able to distinguish between solvent and insolvent borrowers, there is no longer a need for a bank to be reluctant to be seen borrowing at the discount window.
The market analysts have quickly reviewed the Fed loan data and low and behold it turns out that the Fed violated Bagehot's recommendation.  It appears that the Fed lent against securities that the rating services rated "D", as in defaulted.  

As a result of its gamble, the Fed claims it did not lose any money on the loans tied to these securities.  However, have the banks that provided these securities realized all the losses produced by these securities?

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