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.

2

“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)

3

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)

4

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

5

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

6

DW and TAF Borrowing During Crisis

7

DW and TAF Participation During Crisis

8

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

9

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

10

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

11

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

12

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:

Higher borrowing rates on the day of DW visit but not TAF

13

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

14

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

15

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

16

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

17

TAF bidding in the absence of stigma

18

Rising share of banks bid above DW rate

19

Banks bidding above DW rate, did so regularly

20

Banks bidding above DW rate, did so regularly

The majority of banks that bid above the DW rate did so regularly

21

Summary: Existence of Stigma

Strong evidence of existence of DW stigma

Several banks regularly bid in a way consistent with stigma

22

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

23

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

24

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

25

Estimate of Effective DW Stigma Premium

  Full Sample Summer 2008 LehmanMean effective DW stigma 40.8 36.9 142.7Note: Summer 2008 is all auctions between Mar 24, 2008 and Sep 8, 2008.

26

Economic Cost of Bidding Above DW rate

A. Potential Cost

  Full Sample Summer 2008 LehmanTotal per Auction (millions USD) 17.8 15.9 164.4Average per Bank per Auction (millions USD) 0.43 0.26 2.05Bid Above Cost/Interest Paid 12.3% 12.4% 46.5%

B. Realized Cost  Full Sample Summer 2008 LehmanTotal Cost per Auction (millions USD) 6.7 5.5 74.7Average per Bank per Auction (millions USD) 0.25 0.10 2.41Bid 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

27

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

28

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 Expect to see IB effect on same day or day after DW visit

29

Fed Funds Borrow Rate after TAF Visit: Probit Analysis

30

Fed Funds Borrow Rate: Matched Sample Analysis

31

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

Banks’ interbank borrowing rates are higher after DW visit but not after TAF visit

32

TAF bidding in the presence of stigma