Stigma in Financial Markets
NORGES BANK
Government Intervention and Moral Hazard in the Sector Financial September 3 2010
Olivier Armantier, Eric Ghysels, Asani Sarkar, and Jeffrey Shrader
The views in this paper are those of the authors and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.
“In August 2007, ... banks were reluctant to rely on discount window credit to address
their funding needs. The banks’ concern was that their recourse to the discount window, if it became known, might lead market
participants to infer weakness — the so- called stigma problem.”
-- Chairman Ben Bernanke (2009)
Background
DW essential mechanism by which Fed supplies liquidity
Crisis period: Lender of last resort to mitigate systemic liquidity shortage when interbank market is dysfunctional
Normal times: Provide discretionary funding for solvent banks that are temporarily illiquid
Monetary policy: DW rate puts ceiling on interbank market rates
Focus on primary credit
Eligibility: All banks in good standing as determined by its Reserve Bank
Use supervisory ratings and data on bank capital
Collaterized loans
Only overnight loans (until 08/2007)
Effectiveness of DW Lending
Historically, DW effectiveness has been called into question due to the perception of stigma
(e.g. Continental Illinois during crisis that began in 1982)
DW structure revised 2003 to become more like a standing facility
Prior to 2003:
–
Rates below market
–
Discretionary + administratively burdensome
After 2003:
–
Penalty rate (initially 100bp above Target FF rate)
No questions asked
DW Effectiveness During Recent Crisis
August 2007: Fed strongly encouraged banks to borrow from DW
Cut penalty rate from 100 to 50bp
Extended term of DW loans from overnight to 30 days
Send messages to encourage DW borrowing
Banks did not borrow from DW
At least one DW borrower identified in media (Deutsche Bank)
DW stigma was perceived to be a problem
Fed introduced TAF in part to mitigate stigma
DW and TAF Borrowing During Crisis
DW and TAF Participation During Crisis
Lack of Rigorous Evidence of DW Stigma
Anecdotal: DW Stigma often mentioned in the popular press
Suggestive evidence for pre-2007 DW mechanism:
Peristiani (1998): banks in the 1980’s may have become reluctant to borrow from Fed
Furfine (2001, 2003): banks are willing to borrow Fed Funds at rates above the DW rate
Fed funds and DW borrowings are not directly comparable
Ennis and Weinberg (2009) propose a theoretical model in which
stigma emerges endogenously
DW Stigma: Theory
DW stigma from adverse selection in loan markets. Conditions:
DW visit observed or inferred
DW visit more informative than private market borrowing
We are agnostic regarding the source of stigma
Ennis and Weinberg (2009):
Banks sell assets of unobservable quality to pay back IB loans
DW borrowing may be negative signal of asset quality
Banks borrow at IB rate > DW rate
Philippon and Skreta (2010)
Asset quality inferred from participation in government programs outside funding options cost of government programs
Bad banks opt out to signal good quality and get better rates
Questions we Address
Part 1: Existence
Is there DW stigma?
How does incidence of DW stigma vary with bank characteristics and market conditions?
Part 2: Magnitude
What is the magnitude of the effective DW stigma premium (lower bound on the DW stigma premium)?
How did effective stigma premium change during crisis?
Part 3: Market Effects
Effect of DW and TAF visits on banks’ interbank borrowing rates
Contributions
Effectiveness of central bank liquidity supply during crisis
Stigma creates uncertainty as to the price of liquidity
Variation across banks and over time: Response of banks to DW policy becomes difficult to estimate
Liquidity mechanism design
Auction mechanism versus standing facility
Consequences of transparency
Market price effects of disclosure
Results
Existence of stigma:
Strong evidence of existence of DW stigma
Several banks regularly bid in a way consistent with stigma
Probability of bidding above DW rate is higher:
For banks anticipating greater funding needs
When market funding conditions worsen
Size of Stigma:
At least 37bp at height of crisis (at least 150 bp after Lehman)
Asset price effect of DW and TAF visits:
What is DW Stigma?
Stigma exists if banks willing to pay more to avoid borrowing from the DW
Two possible forms of Stigma, wrt:
Market participants:
– Market participants interpret DW borrowing as poor financial health
The Fed:
– May trigger regulatory action (Camel rating, access to primary credit)
– May limit ability to access DW in the future
We mostly focus on stigma wrt market
Methodology: Basic Assumptions
Basic idea: compare banks’ TAF bids with DW rate
TAF and DW borrowing:
Similar eligibility criteria
Same collateral requirement
If rates equal, banks should be indifferent or favor DW borrowing
- DW loans can be prepaid
- DW open every day
TAF and DW are Close Substitutes
Term Auction Facility (TAF) Primary Credit Facility Collateral Same as DW for 28 day loans, additional
overcollateralization of 25% required on 84 day loans
Same broad set of collateral allowed as 28- day TAF auctions
Eligible Banks Primary credit eligible banks in good standing with enough collateral to make minimum TAF bid
All banks with reserve account and high supervisory rating
Minimum bid or loan
amount $5 million None
Frequency Generally once every two weeks Any time during normal business hours Loan Term Generally 28 days or 84 days Overnight through 90 days, renewable by
borrower (up to 30 days before March 17, 2008)
Maximum bid or loan
amount 10 percent of total auction size or up to
available collateral (whichever is smaller) Up to available collateral
Prepayment Not possible Fixed
Rate Determined through competitive bidding
at auctions Spread over FF target (FF+50 bp until 16 Mar 2008, FF+25 bp after)
Similarities
Differences
Methodology: Existence of Stigma
Assumption: Bank has a maximum willingness to pay (MWTP) for borrowing from Fed
Depends on funding needs and outside funding options
Dominated strategy for bank to bid at TAF above its MWTP
Absent DW stigma, rational bank should never bid at TAF above its outside option (i.e. the prevailing DW rate)
If a bank’s TAF bid > DW rate, then this is evidence of
stigma
TAF bidding in the absence of stigma
Rising share of banks bid above DW rate
Banks bidding above DW rate, did so regularly
Banks bidding above DW rate, did so regularly
The majority of banks that bid above the DW rate did so regularly
Summary: Existence of Stigma
Strong evidence of existence of DW stigma
Several banks regularly bid in a way consistent with
stigma
Determinants of bidding above DW rate
Probit model with bank specific random effects
Probability of bidding above DW rate is higher when:
Banks anticipate greater funding needs (by increasing collateral pledged before TAF and having more collateral)
Market funding conditions worsen (i.e. volatility of fed funds borrowing rate increases; LIBOR-OIS spread is higher)
Banks are smaller
Banks bid above DW rate previously
DW stigma premium
DW stigma rate= highest rate banks is willing to pay to avoid DW
DW stigma premium=DW stigma rate – DW rate
Before TAF, bank visits DW when DW stigma rate < MWTP
DW stigma rate is a latent variable
Observable proxies can only provide lower bound
Effective DW stigma premium
For a bank bidding above DW rate,
Effective DW stigma premium = Highest TAF bid - DW rate
Banks are allowed two bids per auction: take the max of these bids
Only defined when banks TAF bid > DW rate
Limitations
Provides a lower bound on the bank’s DW stigma premium
Determinants of effective DW stigma premium need not be the same as that of the DW stigma premium
DW stigma premium may be constant but the effective premium could vary over time
Estimate of Effective DW Stigma Premium
Full Sample Summer 2008 Lehman
Mean effective DW stigma 40.8 36.9 142.7
Note: Summer 2008 is all auctions between Mar 24, 2008 and Sep 8, 2008.
Economic Cost of Bidding Above DW rate
A. Potential Cost
Full Sample Summer 2008 Lehman
Total per Auction (millions USD) 17.8 15.9 164.4
Average per Bank per Auction (millions USD) 0.43 0.26 2.05
Bid Above Cost/Interest Paid 12.3% 12.4% 46.5%
B. Realized Cost
Full Sample Summer 2008 Lehman
Total Cost per Auction (millions USD) 6.7 5.5 74.7
Average per Bank per Auction (millions USD) 0.25 0.10 2.41
Bid Above Cost/Interest Paid 9.1% 5.6% 40.0%
Note: Summer 2008 is all auctions between Mar 24, 2008 and Sep 8, 2008.
• Maximum or potential cost = (TAF bid - DW rate)*Amount bid
• Actual or Realized cost= (TAF stop out rate - DW rate)*Amount received
Summary: Effective DW Stigma Premium
Mean (median) stigma at least 26 (37) bp when TAF stop out rates were consistently > DW rate
Effective DW stigma premium varies across banks
Larger for small banks and banks with more collateral
Market Response to DW and TAF Visit
Is visiting the DW and TAF associated with a subsequent decline in a bank’s interbank borrowing rate?
Expect lower impact after TAF visits if lower stigma
DW visit is not disclosed
Perhaps can be inferred from interbank borrowing activity or balance sheet changes
Timing of DW visits and interbank borrowing:
DW borrowing throughout the day
IB borrowing throughout the day, spike at day-end
Fed Funds Borrow Rate after TAF Visit: Probit Analysis
Fed Funds Borrow Rate: Matched Sample Analysis
Conclusion
Banks preferred to pay premium at TAF to avoid borrowing at DW
Consistent with DW borrowing stigma
Banks paid a premium of at least 37 bp on average to avoid the DW during the height of the crisis
Incidence of stigma varied with bank and market funding conditions
