There’s a quiet revolution happening at the heart of central banking.
On the surface, the inconspicuous language around the shift makes it sound like any other boring back-office central bank protocol. For now, even financial markets haven’t picked up on its significance.
And yet, if it goes as far as some would like, among them former Bank of England Governor Lord Mervyn King, it could change absolutely everything about how finance works, including the end of bank runs as we know them.
So what’s it all about?
In its most extreme incarnation, ‘pre-positioning’, as the concept is becoming known, would turn central banks into what Lord King has colorfully described as a Pawnbroker For All Seasons (PFAS) — albeit, hopefully, without the usual stigma associated with having to pawn one’s valuables.
That’s because banks, just like common folk who have to resort to high street loan sharks, wouldn’t be able to get cash out of a central bank without putting up something of value in case of default.
“The essence of the idea is that banks must pre-position collateral and can issue short-run liabilities only up to the value of such collateral,” King explained to POLITICO. “In this way, bank runs would be eliminated. There would be a limit on the amount of money which “the taxpayer” would be on the hook for.”
No central bank has formally announced a move in this direction, but support for at least a more moderate version of it is rapidly picking up speed. Signs of the shift in thinking are everywhere.
Pledging allegiance to the central bank
Last week, a report authored by heavyweight central banking veterans (the so-called Group of 30) proposed that banks should pre-position enough collateral to cover all their ‘runnable’ liabilities — that is, everything except its capital, long-term debt and fully-insured deposits.
On Thursday, U.S. regulators said they aim to force banks to pre-position collateral at the Fed to cover the risk of acute short-term outflows, such as those that rocked markets last year. At the time, the failure of three regional U.S. banks forced the Federal Reserve to bail out much of the system with a vast implicit subsidy, ultimately guaranteed by the taxpayer.
Key to the failure, central bankers now think, was reluctance to use the Fed’s ‘discount window’, its most important emergency funding facility, due to the stigma attached to it.
Michael Barr, the Fed’s head of Banking Supervision, told a European Systemic Risk Board seminar in November that “even those [banks] that had some collateral pre-positioned weren’t as prepared as they should be.”
To remove that stigma, regulators are now eyeing a yearly ‘fire drill’ in which banks would be forced to borrow from the discount window.
Many officials believe just having banks see in such drills how much of an asset can be turned into cash at the central bank (known in the industry as “the haircut”) would go some way to speeding up liquidity distribution in an emergency. Under PFAS, they say, that benefit would in theory be amplified many times over.
“It would also make bankers, supervisors and central bankers focus much, much more on whether banks and near-banks do in fact have enough eligible collateral, because they have to see it, and revalue it each day,” the BoE’s former deputy governor Paul Tucker, who is a strong advocate of the PFAS system, told POLITICO.
But it’s not just the Fed that’s thinking in this way. Andrea Enria, who retired as Europe’s top banking supervisor at the end of last year, told the same webinar banks should be ready to access central bank facilities and get the liquidity they need at short notice while noting — with respect to Lord King’s proposal — “we should think about something in that direction.”
While the pre-positioning of collateral in various forms has been standard practice for a while at the European Central Bank and the BoE, the shift in thinking comes in the scale of pre-positioning being proposed and in shedding that stigma. For some, that’s a pathway to PFAS.
“The U.S. and European banking failures in 2023 ought to give impetus to the idea Mervyn and I have been pushing for some years,” Tucker said. “Covering 100 percent of short-term liabilities obviously helps in a crisis because the borrowing bank doesn’t run out of eligible collateral.”
Collateral damage
But not everyone is convinced that extensive pre-positioning, let alone PFAS, can work.
The BoE’s deputy governor for prudential regulation, Sam Woods, said in a speech in October he was skeptical that pre-positioning could remove the need for most prudential regulation.
“Fundamentally, a zero-failure regime was incompatible with having a private banking system,” Woods said. “The magic of a capitalist economy lies in competition … But it’s not much of a competition if the game is rigged so that nobody (except the taxpayer) ever loses.”
Among the drawbacks is that an ever-growing sum of bank assets would be permanently locked away, or ‘encumbered’, in the bowels of central banks. This prevents their use as collateral in the wider wholesale financial markets that grease the wheels of the global economy. That could pose an existential threat to private funding markets, especially in a scenario where almost all bank assets end up being absorbed into central bank facilities.
To soothe such concerns, the G30 report leaves the door open for less liquid assets to be ‘pre-positioned’ first — allowing high-quality liquid assets, such as government bonds, to keep circulating through the money markets.
But for Richard Comotto, a long-time repo market observer, a bigger concern is how a central bank will be able to value securities properly if wholesale markets are starved of collateral and not sending reliable price signals.
Stephen Cecchetti, professor of global finance at Brandeis International Business School, cautioned that valuing every asset a bank holds will pose administrative challenges.
”Would every new product that a bank creates have to go to the central bank for some sort of evaluation and a haircut determination before they did it?,” he told POLITICO, adding that, under the plan, the expectation is for these values to be relatively static.
“If the haircuts aren’t moving, but the world is moving, then the risk-adjusted pricing of the assets they might have will be changing faster than the haircuts and will make certain things much more attractive for the banks than other things,” he said. “So this becomes a form of directed credit.”
And directing credit in the Western central bank tradition is taboo, as it turns institutions that have historically been backstops for the financial system into agents of economic policy themselves. Hence the anxiety.
