The Price of Shame: 37 bps

Neither a borrower not a discount borrower be.

February 1, 2011

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501595_hungry_pupMarkets are efficient, so goes the old saw, and rational investors avail themselves of all means possible (within the law) to arbitrage between the present and the future. Don’t they?

There is, for example, some evidence that when the U.S. Federal Reserve announced quantitative easing – that is, taking Treasury Bills out of circulation in order to pump the price (and thereby lower the yield, forcing investors further out on the risk spectrum) – that some captured an easy spread through a facile exercise in front-running. Or so suggests Tyler Durden, at Zero Hedge.

Well, sort of front-running. Not the illegal kind. Since the Fed made its intentions known well in advance, it’s not really front-running. Just money for nothing (and the Fed for free).

Except, however, that some banks appear to be overly scrupulous about how much money they accept from the Fed for (almost) free, depending on how they get it.

Olivier Armantier, Eric Ghysels, Asani Sarkar and Jeffrey Shrader, researchers at the New York branch of the Federal Reserve encapsulate it in the title of a recent paper, “Stigma in Financial Markets: Evidence from Liquidity Auctions and Discount Window Borrowing during the Crisis.”

Banks, troubled and untroubled – or rather illiquid but solvent –  have always been able to borrow directly from the Fed, through the discount window. (The overnight rate – the indicator that gets all the attention — refers to short-term loans between banks.)

But it is, it appears, to be unseemly to make such borrowings –  and no effort is spared, however costly, to disguise the embarrassment, even when the Fed makes it easy.

To be sure, illiquid banks could have borrowed from other, more liquid; but research suggests three reasons why they wouldn’t. First, they were signalling distress, and the potential counterparty faced a situation of information asymmetry; second, a counterparty might have been wary of concentration of risk; third, potential counterparties might wish to hoard assets rather than lend them in a potentially protracted turnaround situation.

Changes in the Fed’s discount window were meant to obviate that, since the Fed is the lender of last resort, able to diversify risks across a number of illiquid situations and equipped with more information about the borrower than other banks would have been.

Almost like no-fault insurance. But it didn’t work that way during the financial crisis. Banks much preferred to pay higher rates for money through the Term Auction Facility, even though functionally it was the same mechanism. As Armantier and company note:

“The TAF was a liquidity facility created by the Fed in December 2007 with virtually the same eligibility and collateral criteria as the DW. By lending term funds at market-determined rates using an auction mechanism, one of the Fed’s objectives in designing the TAF was to eliminate the stigma concerns that were believed to have affected the DW.”

The price of stigma is not cheap. “We find that, during the height of the financial crisis, banks were willing to pay an average premium of at least 37 basis points (and 150 basis points after Lehman’s bankruptcy) to borrow from the Term Auction Facility rather than from the discount window,” Armantier et al., write. “The incidence of stigma varied according to bank characteristics and market conditions. Finally, we find that discount window stigma is economically relevant since it increased banks’ borrowing costs during the crisis.”

There may have been another rationale at work, the researchers suggest. “Although not consistently statistically significant, our results are consistent with the hypothesis that banks visiting the DW may face a moderate increase in borrowing costs and a moderate decrease in stock prices, relative to banks that do not visit the DW.”

Ah yes, the value of keeping up appearances.

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