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What is going on?

Why did the ECB inject massive amounts of liquidity on August 9th? Why do they need to continue these operations up to now? The exact details are not yet fully known (correctly so - in a crisis full transparency may have disastrous effects), but obviously liquid banks had no longer been willing to lend their excess funds on the money market to other banks.

The key reason was that lots of banks, and not just banks but also conduits and structured investment vehicles, borrowed short to lend long to finance attractive, high yield investments such as investment in AAA rated bonds issued on the US subprime mortgage markets. Suddenly, bankers realised that these investments may not be such a good deal. So they refused to refinance these long term loans. The issuing institutions, in urgent need to roll over there asset-backed commercial paper, got trapped. The price of many asset backed securities dropped dramatically. At the same time, the money market rates spiked up. There has been a run on markets, triggered by the fear of fire sales.

The best (and quite frightening) explanation is given by Gillian Tett in FT: Why financiers have missed the new monster

I like in particular the quote:

“But if this saga is striking, what is truly shocking is that the risks posed by this funding mismatch have gone so unnoticed, for so long. Never mind the fact that even a first year economics student could see that creating ABCP vehicles in this way looked a bit odd.”

For more details, see also her news on: See also this article in the Economist:

Since the inter bank money market dried out, demand for central bank money held by banks as reserves (part of the monetary base) shot up. Central banks, trying to prevent disruption of financial markets, provided additional liquidity to the market – they acted as lender of last resort. 

What about equilibrium on the money market? How does it work in a textbook model? One problem is that our textbooks usually do not cover central banking operation during crisis periods. This holds in particular for those modern graduate textbooks presenting monetary policy in a framework of perfect credit markets with no real role for money). You need detailed institutional background information which students usually find pretty boring most of the time. Still, it pays to first have a look in good old-fashioned textbooks (such as Blanchard/Illing ) to get some basics on bank runs and on open market operations. (for the German edition, see on page 122 (PDF 43 KB) and pages 750/51 (PDF 85 KB) )

A nice textbook explanation for the ECB intervention has been provided by Mark Thoma at this link. His explanation is not quite correct, since it was not really the supply of reserves which had been fixed, rather the rate of interest. So the line R2 was not vertical; instead the horizontal line FF has been fixed (at around 4% by the ECB and 5.25 % in the US). Essentially, however, the effect is exactly the same as described by Mark.

An intriguing question is why the ECB did not just offer additional base money via its Marginal-Lending-Facility which provides overnight liquidity to banks from the Eurosystem at a rate which is usually one percentage point higher than the Main refinancing rate. During a crisis, central banks have to make tough decisions within very short time. They have to decide against what type of collateral to lend: Should you accept just AA rated securities, or should you extend lending by also accepting junk bonds or even toxic waste as collateral; should you lend at a penalty rate; should you allow just for overnight borrowing or extend lending to longer periods, and many other tough questions.

In the US, operating procedures are quite a bit different than in the Euro area, but the key mechanisms are very similar. The Fed calls the Marginal-Lending-rate the Discount rate. On August 17, the Fed cut its rate for its Discount Window by 50 basis points to encourage borrowing. At the same time, loans have been allowed for a term up to 30 days (not just overnight). Finally, the Fed emphasized that a wide-range of collateral will be accepted (in particular mortgage-backed securities).

Stephen Cecchetti from Brandeis International Business School had been working at the Fed in New York during the LTCM crisis, so he has inside knowledge to evaluate what happened. At the ECB watchers conference in Frankfurt organized by the CFS (Centre for Financial Studies) he gave an excellent  account of what was going on during August at the Fed.

Read next section: Why did it happen? What went wrong?