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COVID-19 and Fed emergency facilities by Ashish Deccannawar
COVID-19 and Fed emergency facilities
by Ashish Deccannawar
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abstract
quicker announcement but lag in the operational details
COVID-19 led to systemic liquidity crisis around March 2020. The Federal Reserve Board (Fed) took extraordinary efforts and reacted with a lightning speed to alleviate this exogenous shock. Fed created number of liquidity facilities under the section 13(3) of the Federal Reserve Act citing unusual and exigent circumstances. Each and every facility played a critical role in not only stabilizing the American economy but also leading to rapid recovery. The aim of this article is to provide view on effectiveness of these emergency facilities that stabilized the financial markets and highlight the key differences between 2008 financial crisis era facilities and COVID-19 related emergency facilities.
During the COVID-19 crisis the Fed re-introduced most of the 2008 crisis era facilities without taking much time. However, the Fed lagged in providing operational details on how these facilities can be used. Announcements of these facilities did provide the positive signal to the market; however, the initial phase of these facilities lacked guidance on operational implementation on these facilities. Banks in the initial phase struggled and were in the limbo on how they can implement these facilities to benefit the American economy.
Fed Discount window lending facility is considered as lending of last resort and thus has a stigma associated with tapping into Fed’s discount window facility. One would wonder if the similar stigma is also associated with the Fed’s emergency facilities. Based on the 2008 Financial Crisis experience, it was clear that pretty much most of the large banks have drawn down on the Fed’s emergency facilities that were made available in the Financial Crisis. In the 2020 COVID-19 crisis, banks were likely to tap down on most of the facilities either to manage their liquidity or to achieve affordable funding compared to other expensive funding sources. But how banks reacted to these facilities and whether they draw down on these facilities or not is yet to be seen in the published data.
Based on the current available data and announcement from the Chair of the Federal Reserve, Jerome Powell, it is clear that banks are even encouraged to draw down on the discount window facility. Based on the March 2020 data, it was confirmed that discount window usage more than doubled in a two-week time (i.e., $11 Bn to $28 Bn). There is also anecdotal evidence where large US banks made announcements noting that they will be drawing down from the Fed’s discount window facility to reduce the stigma associated with it. Clearly, stigma associated with using these facilities did not deter banks from using these facilities to appease COVID-19 liquidity concerns.
The table below provides the summary of emergency facilities provided by the Federal Reserve Board.
Summary of facilities:
1
The section below covers details on some of the facilities that had significant impact on the markets.
1. Primary Dealer Credit Facility (PDCF) PDCF was introduced by the Federal Reserve Board (Fed) on 17th March 2020. The PDCF facility intended to allow primary dealers to support smooth market functioning and facilitate the availability of credit to the businesses and households.
As of May 2020, there were around 24 primary dealers in the US that acted as trading counterparties to the New York Fed to support Federal Open Market policies, which include market making for fixed income securities and equities, bidding in the treasury auctions, etc. Primary dealers largely rely on the secured and unsecured funding from the financial markets with funding term ranging from short term (Overnight to weekly funding) to medium term (up to 90 days in funding); however, due to COVID-19 fears, Primary dealers faced challenges to rollover unsecured term funding in the market as investors were willing to lend in short tenor and were staying away from lending over 90-day tenor. The PDCF facility largely helped to alleviate the Broker-Dealer’s term funding concerns as they were allowed to pledge investment grade debt securities, Commercial Papers (CPs), municipal debts, and certain equity securities.
The PDCF facility was also introduced in the 2008 Financial crisis; however, one major change in 2020 is that this facility allowed up to a 90-day term vs. 2008 when the PDCF facility allowed only the overnight funding to the primary dealers. In 2008, most of the primary dealers rolled over their overnight funding as PDCF facility was available from March 2008 till April 2009. Introduction of the term funding really helped Broker Dealers to maintain their Liquidity Coverage Ratio (LCR) as they could rely on the term funding over 30 days to count this as an outflow beyond 30-day LCR time horizon.
Based on the Paper published by the Fed2, it was observed that peak usage of the PDCF facility in 2008 was ~40 billion vs. ~35 billion seen in April 2020. The introduction of this PDCF facility in 2008 helped in alleviating the market. Current evidence from 2020 data (as shown in the Figure 1) indicates that PDCF facility is following the same path of usage as of 2008. As shown in the figure 1, the 2020 PDCF facility just peaked within a month of the introduction indicates that it has its fair share in providing the credit to businesses and households and stabilizing the market.
Figure 1 - PDFC loans outstanding, 2008 vs. 2020
Source: Federal Reserve form H4.1 Note: This chart represents the weekly average of daily loans made at the PDFC.
2. Commercial Paper Funding Facility (CPFF) CPFF was introduced by the Federal Reserve Board on 17th March 20203. The CPFF facility intended to support smooth market functioning and to provide liquidity backstop to the commercial paper market.
Companies use commercial papers as a short-term funding vehicle to run the businesses. The COVID-19 crisis led to the dislocation of the commercial paper market, which made commercial paper issuance illiquid and expensive. Based on the anecdotal experiences, investors were willing to extend the credit mostly on the overnight basis, and firms were struggling to raise funding over longer horizon. The Federal Reserve stepped in to backstop this market and started purchasing the commercial papers through this facility. This facility alleviated the market’s liquidity concerns, but the funding through this facility still remained at the elevated levels. Generally, high credit quality firms are able to access this market, as investors for the commercial papers are mostly prime money market funds, who seek to invest in short- term high quality assets.
Clearly, Fed’s action to introduce CPFF facility worked really well and reduced the panic in the unsecured funding from Commercial papers. Based on the comparison to the financial crisis of 2007-2009, facility introduced in COVID19 had limited usage, however COVID19 facility helped the market to achieve return to normal conditions4 .
COVID-19 - 2020 Usage:
3. Money Market Mutual Fund Liquidity Facility (MMLF) The Federal Reserve Board announced the introduction of MMLF on March 18, 2020, but the actual facility became effective on March 23, 2020. The MMLF facility intended to improve liquidity in the market and to stabilize the outflows from the panic redemption of the prime and municipal money market funds by providing the liquidity back-stop to avoid “breaking the buck” scenario. Similar redemptions in these funds were also experienced in the 2008 financial crisis and in the 2011 European Debt Crisis. In response to the similar behavior seen in 2008, Federal Reserve Board had introduced Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) on September 18, 20085 .
In the Money Market Mutual Funds, investors can avail three types of Mutual Funds. First, Prime Funds that invest in short term debt instruments issued by corporates (non-financial) and financial firms. These short-term debts include products such as Certificate of Deposits (CDs), Commercial Papers (CPs), and floater (i.e., floating rate notes). Second, tax-exempt funds government-only funds (i.e., Muni Funds). Tax exempt funds invests securities issued by the state and local governments. These securities are also called as Municipal Securities or Munis. Third, taxable government-only funds. These taxable government funds invest in the securities issued by the US Government that includes U.S. Treasury and agency securities.
At the peak of COVID-19, around March 2020, financial markets experienced liquidity shock. Investors concerned with the viability of the financial, non-financial and muni sector, started a panic redemption leading to the fire sell. This massive outflow in prime and muni funds looked for flight to quality and market saw inflows in the taxable government-only funds. See the graph below6 in Figure 2; at the peak of COVID-19, there was outflow from the redemption from Prime and Muni funds but with the introduction of MMLF facility (vertical black bar), prime and Muni MMFs stabilized with investor buying in these funds.
Figure 2 - Domestic Prime and Muni MMF decline and rebound
4. Paycheck Protection Program Liquidity Facility (PPPLF) PPPLF was announced by the Fed on 9th April 2020, but the actual launch of this facility happened on April 16th, 2020. Unlike other facilities, PPPLF was unique to the COVID-19 crisis and there was no comparable facility introduced in 2008 financial crisis.
With the news of rapid spread of COVID-19, the US government took the swift action of shutting down the economy. As the ever-booming economy came to a sudden halt, it brought in several economic challenges. Several small- and medium-sized businesses in a service industry were particularly hard hit. With no revenue due to complete shut-down, it was challenging for them to keep employees on the payroll, pay rents and utility bills. Additionally, the credit market literally froze to these small and medium sized businesses, as banks were hesitant to extend credit due to COVID-19 uncertainties. In response to this situation, the Fed in collaboration with the Small Business Administration (SBA) announced the PPPLF to cover the payroll, mortgage/rent, and utilities cost. The whole point of this facility was to encourage liquidity constraint banks to support PPP loans to make credit available to small and medium sized businesses, which will spur the business activity in the US market
PPPLF effectiveness
There are several anecdotal incidences on how PPP loans got abused but at large these loans achieved the intended objectives of generating credit and liquidity to the small and medium businesses to avoid insolvency. Initially, the PPPLF was only intended to the Banks which later got extended to the non-banks and financial technology (“Fintech”) firms. The liquidity facility provided by the PPPLF was crucial to the success of the PPP loans. This facility essentially took out the counterparty default risk, liquidity risk and market risk from the financial institution’s lending profile and essentially provided them with a fee income for underwriting the PPP loans. As seen from the Figure 37, the PPP loans reached several industries, but one could argue that these loans were not distributed equally raising the question regarding equality.
Figure 3 - PPP Loans based disbursed as per the NAICS code
Sources: Paycheck Protection Program (PPP) Report, Small Business Administration; Census Bureau, Statistics of US Businesses
summary
Clearly, emergency actions and facilities announced by the Federal Reserve Board to fight the 2008 Financial Crisis and COVID-19 liquidity crisis worked very well. There won’t be any surprise if the Federal Reserve Board announces the similar facilities in the future crisis as these actions have a proven track record to stabilize the liquidity crisis.
references
1. only AAA-rated securities are accepted: commercial mortgage-backed securities (CMBS), collateralized loan obligations (CLOs), and collateralized debt obligations (CDOs). Other eligible securities as specified above are accepted if rated investment grade (such that BBB- securities and above). Specifically, investment grade commercial paper is accepted: commercial paper rated both A1/P1 and A2/P2. 2. Published article in Liberty Street Economics – Federal Reserve Bank of new York refers to the peak use of
PDCF facility in 2008 and in 2020 (Mid-March to end of May). https://libertystreeteconomics.newyorkfed.org/2020/05/the-primary-dealer-credit-facility.html 3. https://www.federalreserve.gov/newsevents/pressreleases/monetary20200317a.htm 4. Nina Boyarchenko, Richard Crump, and Anna Kovner, “The Commercial Paper Funding Facility,” Federal
Reserve Bank of New York Liberty Street Economics, May 15, 2020, https://libertystreeteconomics.newyorkfed.org/2020/05/the-commercial-paper-funding-facility.html. 5. Michael J. Fleming, “ Federal Reserve Liquidity Provision during the Financial Crisis of 2007-2009,”Federal
Reserve Staff Reports, July 2012’ https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr563.pdf 6. Marco Cipriani, Gabriele La Spada, Reed Orchinik, and Aaron Plesset, “The Money Market Mutual Fund
Liquidity Facility,” Federal Reserve Bank of New York Liberty StreetEconomics, May 8, 2020, https://libertystreeteconomics.newyorkfed.org/2020/05/the-money-market-mutual-fund-liquidity-facility.html 7. Data sourced from Paycheck Protection Program (PPP) Report, Small Business Administration; Census Bureau,
Statistics of US Businesses (SUSB)
author
Ashish Deccannawar
Ashish Deccannawar is a Senior Manager at one of the top 10 largest Banks in the U.S. and leads Liquidity Strategy and Governance function for their Consolidated U.S. Operations. Ashish is an expert in Liquidity risk, and Bank’s balance sheet management functions. Prior to his current role, he worked as a Senior advisor at one of the Big four consulting firms advising Global Systemically important Banks (G-SIBs).
Ashish has extensive experience in advising US and foreign Banks in the Liquidity Risk space. Topics of his interest include Liquidity Stress Testing, Cash Flow Projections, Fr2052a reporting, Funds Transfer Pricing (FTP), and Net Stable Funding Ratio (NSFR).
