Wednesday, June 24, 2015

IMF's Vinals Says Central Banks May Have to be Market Makers

This news item on Reuters is quite significant. It quotes senior IMF official Jose Vinals as saying that Central banks "may need to become market makers of last resort if there is not enough liquidity during volatile sell-offs."  The comments were made at a recent speech in London. You can view a video of them from from this page on the IOSCO web site (see video for Panel 4 and start at the 45:58 mark)

We have already covered this liquidity issue here on the blog quite a bit. It is obviously a concern to the IMF and Central bankers. Below are some quotes from this Reuters article and then a few added comments.

"Central banks may need to become "market makers of last resort" if there is not enough liquidity during volatile sell-offs, a senior International Monetary Fund official said on Thursday.

Regulators worry that when interest rates begin rising from their prolonged low levels there will be a stampede for the exits by bond investors and that markets won't have the liquidity or capacity to deal with it smoothly.

The prospect that the Federal Reserve may start raising rates later this year has already prompted "taper tantrums" or severe volatility in global financial markets.

Jose Vinals, director of the IMF's capital markets department, said market liquidity has shrunk as capital requirements on banks have increased but that there was no simple relationship between the two.

Central banks buying bonds to conduct unprecedented stimulus programmes over the last three years -- most recently the European Central Bank -- have also been blamed for sucking volume out of the market, making it less liquid.
Vinals said it was unclear whether markets were simply more volatile or whether there were systemic consequences, but it would take time to find a solution,
"The time it takes for the global regulatory community and central banking world to find a solution this time may be longer than the time where one episode of big illiquidity happens," Vinals told a meeting of the International Organization of Securities Commission (IOSCO) in London.
"Then the question is what to do. In my view the only thing that can be done at that time is that central banks should become again market makers of last resort."
Ashley Alder, chief executive officer of Hong Kong's Securities and Futures Commission, said central banks acting as market markers of last resort was the "last thing" he wanted to see.
"If you react to that by piling more intervention on intervention, you encourage more untoward risk taking and you end up with even greater amount of mispriced risk," Alder told the conference."
My added comments:
I am seeing this concern over a possible lack of liquidity show up a lot in recent comments by the IMF and other Central bankers. Christine Lagarde mentioned it in her recent blog article summarizing the annual IMF review of the US economy. Both Nouriel Roubini and Jim Rickards had recent articles about it. More mainstream fund managers are expressing concern about the possibility for a "systemic shock" event.
When you combine these warnings with the recent Bank for International Settlements (BIS) Credit Risk Management report, it gets your attention. Here is a quick bullet point list of takeaways from all this:
- Central bank easy money policies (QE and artificially low interest rates) have created risks that must be watched carefully when the effort is made to "normalize" things by raising interest rates (which really means when the efforts to artificially suppress rates stop)
-Central bank buying of bonds has "been blamed for sucking volume out of the market, making it less liquid"
-Central banks are in a very tough spot when they try to unload these bonds which will cause interest rates to start going up (perhaps in an uncontrolled manner depending upon how markets react)
-Just raising short term rates (without even trying to sell off their bonds) may trigger a major move out of bonds creating a very illiquid market (too many sellers, not enough buyers) as the market tries to front run the Central banks
- Jose Vinals says if all this happens "Central banks may need to become market makers of last resort" yet again
-The BIS report says a big potential problem is that during the easy money policies investment capital has flowed into funds that promise investors instant liquidity while the fund is invested in longer term bonds. A "run on the fund" if interest rates start rising is a real concern and could create illiquid markets
When you see this issue talked about this much by the IMF, the BIS, and also leading credible analysts outside the system, you must take this risk seriously. If the bond markets freeze up due to illiquidity (too many people trying to get out at once), it could definitely be the trigger to another big financial crisis like Jim Rickards and others are expecting. Keep in mind that there are also many trillions of derivatives tied to interest rate movements and bond prices.
It goes without saying that if the Central banks have to step in once again as "market makers of last resort" to try and save the system, what remains of public trust in the system is going to be severely tested. If the crisis is too big for the US Fed, the IMF could try to step forward like Jim Rickards has predicted will happen. But it is very unclear how the public would respond to this if they are dealt another big crisis and they blame Central bank policies for causing it. It will all depend on who the public trusts at that point in time.
This is not a forecast that this will happen. But it is an admonition for readers to watch this issue very carefully in the coming weeks and months ahead.

Added note 8-6-15: A full list of systemic risk warnings can be found on this blog page 

No comments:

Post a Comment