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The Fed's Dilemma

The Origin of the Dilemma

The Federal Reserve (Fed) and other central banks currently face a dilemma. A strong central-bank balance sheet is essential for the quality of a currency and the stability of a financial system. Unfortunately, the financial crisis has seen substantial changes in the balance sheets of the world's major central banks.

Besides the much-discussed quantitative easing (the expansion of central banks' balance sheets), there has also been substantial amounts of "qualitative easing" (balance-sheet policies that deteriorate the average quality of central-bank assets).[1]Quantitative easing may imply qualitative easing if the new assets on the balance sheet are of lower quality than the average existing quality of the assets held.

The Federal Reserve, until September 2008, engaged in qualitative easing with an almost constant balance-sheet total (i.e., a limited quantitative expansion). The Federal Reserve swapped liquid and low-risk assets against relatively more illiquid and riskier ones held by the banking system. New credit programs appeared while US Treasury bonds were sold, supporting a faltering banking system faced with a destabilizing liquidity constraint.

Thus, the granting of credit to the troubled banking system did not expand the balance-sheet total. As a consequence, banks' balance sheets improved and the central bank's balance sheet commensurately deteriorated. The Federal Reserve System has become the very type of "bad bank" that they were themselves trying to rescue. This has even raised the question of the possible insolvency of central banks.

The average quality of the assets backing the dollar (the assets held by the Fed) deteriorated at an even faster pace after September 2008. There was a substantial expansion of the balance sheet through an increase in the monetary base.

The increase in emergency credit programs was financed mainly by (excess) bank reserves and by accounts of the Treasury held at the Fed. A new stage in quantitative easing was reached when, in the spring of 2009, the Fed started buying government bonds, agency debts and mortgage-backed securities directly.
The Problems of Exit Strategies

The dilemma consists then in restoring a strong central-bank balance sheet without harming the financial system. Undoing the qualitative and quantitative easing by reversing the balance-sheet policies is easy only from a technical point of view, as, for instance, Ben Bernanke has pointed out.
"The Federal Reserve System has become the very type of 'bad bank' that they were themselves trying to rescue."

In order to reduce the size of its balance sheets, the Fed could simply sell the government bonds and mortgage-backed securities, end emerging programs, increase collateral standards again, and discontinue the roll over or renewal of loans to the banking system. In fact, the demand for these emergency programs will likely shrink as the economic situation improves.

The problem, however, is that the reduction of the balance sheet would undo policies enacted in order to support the financial system.[2] By selling securities, the Fed would reduce the amount of bank reserves and thereby reduce liquidity in the interbank loan market. By not renewing loans to the banking system, the Fed could cause a liquidity constraint to reemerge. And as a result of increasing collateral standards, banks might not have enough high-quality assets to sustain the level of credit they currently maintain.

In sum, quantitative tightening would decrease interbank and overall liquidity and could lead to a stronger, deflationary credit tightening. The financial crisis could become aggravated again with destabilizing effects.

However, there is a way to reverse part of the qualitative easing without reducing the balance-sheet total or current levels of bank reserves: central banks could simply undo the swap of liquid and low-risk assets against relatively more illiquid and riskier ones.

The Fed, for instance, could end some of the emergency-lending programs in which collateral of low quality is accepted, thereby decreasing excess bank reserves. As compensation, the Fed could buy government securities, thus increasing bank reserves.

Doing so would increase the average quality of the assets backing the monetary base while keeping the balance sheet and bank-reserve totals constant. However, the loans collateralized by risky and illiquid assets would be removed from the Fed's balance sheet, and government securities would be increased. In turn, government securities would disappear from the banking system's balance sheets, and the low-quality assets formerly used as collateral would no longer be used to guarantee central-bank loans.

Yet, if these low-quality assets are fully integrated into bank balance sheets without the possibility of using them as collateral for central-bank loans, the interbank lending market may seize up again. Valued at market prices, these assets would probably endanger the solvency of many banks. Thus, the risks regarding the value of these assets would slacken the desire to lend to other banks.

The solvency of counterparty banks is unclear due to the bad assets on their balance sheets. Therefore, interbank liquidity would be reduced and banks may restrict the extension of credit in order to restore their liquidity and solvency.

This lack of liquidity would place negative pressure on many financial institutions, further reducing confidence in counterparties and the system as a whole. A downward spiral of evaporating liquidity, credit contraction, and bankruptcies might lead, in the extreme, to the collapse of the financial system.

In fact, the financial crisis was caused by solvency problems that led to a liquidity constraint. Central banks tried to fight this by increasing the availability of liquidity and buying or loaning against the same bad assets that caused the solvency problems. If central banks sell those assets again or stop accepting them as collateral, the same solvency problems will reemerge, along with the preexisting liquidity issues.

Paradoxically, by buying and accepting bad assets, the central banks did not fix the solvency problem: they merely delayed the inevitable. The bad loans did not turn "good" by changing hands or being accepted as collateral by central banks. Hence, the problem remains and exit strategies can only be successful if the quality of these assets changes or their quality is acknowledged and banks are recapitalized accordingly. Therefore we are faced with two possible solutions for exit.
Solution Number One: Asset-Price Inflation

The first solution to the exit problem consists in simply waiting for the bad assets to become good assets. Unfortunately, there is no reason for the majority of these assets to turn good unless nominal prices (housing prices, etc.) are reinflated again to their prebust levels.
"The central banks did not fix the solvency problem: they merely delayed the inevitable. The bad loans did not turn 'good' by changing hands or being accepted as collateral by central banks."

Therefore, the central banks can actively try to improve the quality of their assets and accepted collateral by increasing the money supply, causing prices to rise. Moreover, price inflation causes the real debt burden of the loans to decrease, thereby increasing the possibility of an improvement in the performance of bad loans. Thus, central banks can pursue a policy of increasing the money supply in order to inflate (for example, housing) prices again.

Central banks could also directly buy troubled assets to bid their prices up (the Fed already commenced this policy when it started to buy mortgage-backed securities). When housing prices increase, the value of mortgage-backed securities will also increase, improving the solvency of the banking system. Thus, a solution for the reversion of the qualitative easing is price inflation.

Yet, this solution has several disadvantages. First, it is only a partial exit strategy. It is true that it can undo the compositional changes of qualitative easing. For instance, central banks could buy good assets, thus increasing the money supply and causing prices to rise sufficiently.

Thus, central banks could not undo the quantitative easing as an exit strategy but would have to reengage in significant additional quantitative easing to rectify the newly created problems. In other words, one cost of quantitative easing is that central banks may reverse the previous episodes of qualitative easing. By reversing the qualitative easing, central banks would create an even bigger exit problem in the quantitative easing that this would imply.

Another salient problem consists in the danger of hyperinflation. If central banks increase the money supply to the extent that housing prices increase back to their prebust levels, people may lose confidence in their currency's long-term stability. Relative housing prices must adjust and fall relative to other prices. Increasing them nominally to their prebust levels (and possibly higher) would require a substantial increase in the money supply. This large monetary inflation could lead to a loss of confidence, and possibly to hyperinflation.

A further problem consists in the question of proportionality. If the central bank does not increase the money supply enough, bad assets will remain bad, leading to solvency problems. If the central bank increases the money supply too much, a hyperinflation will become probable.
Solution Number Two: Exit and Recapitalization of the Banking System

The second, and the only viable, solution consists in exiting from the qualitative and quantitative easing and thoroughly addressing the problems involved. Central banks would return to balance sheets similar to those before the crisis broke out. This is technically not difficult to achieve, as has been stressed by Ben Bernanke and a multitude of his fellow central bankers.
"The central banks can actively try to improve the quality of their assets and accepted collateral by increasing the money supply."

Bad loans and assets would be returned to banks' balance sheets. Valued at market prices, these would result in the insolvency of at least some main financial institutions. While this might be considered problematic and harmful, it is the best option at hand.

The insolvency of a large part of the banking system would only acknowledge a fact that has been concealed, and whose consequences have been delayed, causing important moral hazards. The alternative is to continue the existing policies, with the danger of an enduring recession not unlike the one in Japan.

Banks knowing they are "too big to fail" have a tendency to behave more recklessly. The real challenge to this exit strategy is in finding a way to orderly fix the insolvency problems of banking institutions without causing, or exacerbating, future moral hazards.

There are several solutions to the looming insolvency problem of banks. First is recapitalization by the market. Banks would compete to receive new capital on the market. This solution will probably result in limited success as it depends on finding investors willing to fund insolvent companies.

Second is a recapitalization by the government. The disadvantage of this option is that scarce resources would be shifted to help the banking system at the expense of other areas of the economy. As these resources are needed in other places in order to restructure the economy, the situation in other industries could consequently worsen, leading to more bad loans and additional problems for the banking system. Moreover, recapitalization by the government would instigate further moral hazards.

Third, the most radical solution, would be an insolvency process for the banks. During this insolvency process, the restructuring of ownership might be accelerated by turning bank creditors directly into equity holders.

The real value of the assets of many banks is currently lower than their outstanding liabilities, giving rise to the insolvency problem that triggered the financial crisis. The qualitative and quantitative easing have not solved this problem, but only delayed the solution. It will only be possible to reverse the previous easing when the insolvency problems are fixed.

This can be done by acknowledging the real value of the assets on the books of the banks and turning creditors of the banks into shareholders pro rata. Banks could start operating and trusting each other again, and the easing could be undone accordingly. Existing shareholders will lose via a dilution of their current holdings through new share issuances, while secured creditors and liabilities will be reduced accordingly.
Conclusion

The root of the current financial crisis was an artificially induced boom in the real economy, and asset-price markets that subsequently turned to bust. The bust led to a reduction in the values of many assets owned by banks.

Thus, the banking sector found itself crippled by insolvency problems, consequently causing liquidity problems. The readjustment of the economy and relative asset prices cannot be solved by increasing the quantity of money or shifting bad assets from banks' balance sheets to central banks' balance sheets.

The problem can only be solved by acknowledging it. Turning bank creditors into equity holders would fix the banks' solvency problems and would increase confidence in the financial sector, thus also improving the liquidity situation.

If this is done, the balance-sheet policies of quantitative and qualitative easing can be reversed by selling the bad assets, buying back the good assets, and refusing to roll over emergency loans. Otherwise, the policies cannot be undone without instigating the breakdown of the financial system or risking hyperinflation.