TLDR: Cbankers’ enthusiastic embrace of prepositioning points to growing acceptance of former BoE governor Lord Mervyn King’s ‘Pawnbroker For All Seasons” model. But some worry it might have grave consequences for free markets.
There’s a quiet revolution happening at the heart of central banking, but you wouldn’t necessarily know it.
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 monetary policy is conducted.
So what’s it all about?
In its most extreme incarnation, the concept would restructure central banks into what former Lord King has colourfully described as ‘Pawnbrokers For All Seasons’ (PFAS).
Under the plan, which aims to eliminate the need for deposit insurance by making bank runs nigh impossible, an ever-growing sum of bank assets would be permanently encumbered in the bowels of central banks. Unlike with actual high-street pawnbrokers, borrowing from which is seen as socially taboo, banks would draw on central bank liquidity as and when needed with little to no stigma.
While no central bank has formally announced a move in this direction, a pick up in references by central bankers calling for the need for more ‘prepositioning’ to prevent the sort of liquidity troubles experienced by markets signals a step towards a light touch version of the plan laying the groundwork for a PFAS model eventually.
“I do think that the phrase “pre-positioning collateral” is very much a shorthand for the basic principle of my scheme,” King told POLITICO.
“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 net of the haircut determined by the central bank. In this way, bank runs would be eliminated. There would be a limit on the amount of money for which “the taxpayer” would be on the hook.”
Pledging allegiance to the central bank
Signs of the shift in thinking are everywhere.
At the Seventh European Systemic Risk Board annual conference last November, Michael Barr, Vice-Chair for Supervision at the Fed, was among several supervisors who hinted the idea was being considered more formally. “As we continue to look at how we can enhance our own operations; we are also emphasising to firms the importance of preparedness to tap contingency funding sources, which means pre-positioning collateral and testing at regular intervals,” he told the webinar.
As Barr noted, “even those that had some collateral pre-positioned weren’t as prepared as they should be” when troubles started last Spring. That meant that even one of the Fed’s best-established tools, the discount window, ended up being underutilised.
While pre-positioning of collateral at central banks has been standard practice for a while now, notably at the ECB and the BoE, where the shift in thinking really comes is in the scale of pre-positioning being proposed as well as in normalising and shedding that pre-existing stigma.
That problem isn’t limited to the U.S. The Bank of England deliberately doesn’t publish the lendings from its own discount window for just that reason, while use of the ECB’s marginal lending facility is published every day — a clear red flag that someone, somewhere, is in trouble.
The ECB’s former top supervisor, Andrea Enria, told the same webinar banks should be ready to access central bank facilities and get the liquidity they need at short notice. “Pre-positioning of collateral is an important issue on which we are now trying to focus our banks’ attention,” he said, while noting — with respect to Lord King’s proposal — “we should think about something in that direction.”
A major challenge in getting liquidity out quickly in a crisis, as became abundantly clear in 2023, was the paperwork and due diligence needed to assess more complex bank assets once their supply of top-quality collateral, known as high-quality liquid assets or HQLA for short, had run out.
In the first instance, central bankers believe just having banks pre-assess these assets in a way that banks know what proportion can be liquefied easily at the central bank (known in the industry as “the haircut”) would help ease that process and allow them to extend liquidity more quickly.
But things are stepping up beyond mere administration.
This month, the G30 pushed the pre-positioning idea to the top of the regulatory agenda, formally recommending that banks should aim to pre-position “enough collateral after haircuts for tail-event credit risks, to cover all runnable liabilities — that is all liabilities excluding capital, medium-to-long-term debt, swap liabilities, and insured deposits.”
On Thursday, meanwhile, Michael Hsu, the acting head of the Office of the Comptroller of the Currency, said U.S. regulators should aim to propose new rules this year to force banks to pre-position enough collateral at the Fed to cover the risk of any acute short-term outflows, such as those suffered last year by Silicon Valley Bank and Signature Bank.
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.
Crucially, this will include a requirement for banks to do a yearly ‘fire drill’ and borrow from the Federal Reserve’s discount window in a bid to de-stigmatise the use of central bank liquidity.
This follows on from the G30 advice that “improving the LoLR system in the United States requires reducing the stigma of using it and easing its actual use. One step would be adjusting its terms, that is, lowering the costs of the secondary credit facility and possibly lengthening the duration of loans.”
Since normalising borrowing from the lender of last resort is also an essential part of the PFAS vision, for some, that’s a signal the pathway to the regime is now opened.
Indeed, as the G30 noted, a more extreme version of this proposal could eventually “do away with the LCR and HQLA requirements, as the posting would assure 100 percent of any potential liquidity needs, and it would not envision having deposit insurance or any committed liquidity facility.”
The report added: “This is in essence the ‘pawnbroker for all seasons’ (PFAS) of Mervyn King and Paul Tucker, which also extends such access to non-banks.”
In direct correspondence with POLITICO, the BoE’s former deputy governor, Paul Tucker, said that the US and European banking failures in 2023 “ought to give impetus to the idea Mervyn and I have been pushing for some years”, adding that “covering 100 percent of short-term liabilities obviously helps in a crisis because the borrowing bank doesn’t run out of eligible collateral. But, vitally, 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.”
Collateral damage
But not everyone is convinced the model can work and many worry about its impact on free markets.
In a speech in October last year, the BoE’s deputy governor for prudential regulation Sam Woods said he was skeptical that pre-positioning could obviate the need for most prudential regulation.
“Fundamentally, a zero failure regime is incompatible with having a private banking system,” Woods said. “The magic of a capitalist economy lies in competition – which drives down costs for customers, spurs innovation, and brings the best ideas to the top. But it’s not much of a competition if the game is rigged so that nobody (except the taxpayer) ever loses.”
Stephen Cecchetti, professor of global finance at Brandeis International Business School and formerly of the Bank for International Settlements, cautioned that valuing every asset that a bank holds might pose 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 way faster than the haircuts and will make certain things much more attractive for the banks than other things. So this becomes a form of directed credit,” he said.
But, he added, he had been persuaded that while there is a complexity with credit creation banks should still be able to do it. “But creating a line of credit in the King world would require some capital… So you’re going to have to be over-capitalised relative to what your on balance sheet activity looks like, if you want to create off balance sheet activity.”
Yet, others worry it might not take a full PFAS model to disrupt the world’s most established financing markets.
Richard Comotto, a long-time observer of the repo markets, said he worried how a central bank could value securities if wholesale markets were starved of collateral and not sending reliable price signals.
One of the concerns is that once collateral is pre-positioned at the central bank it becomes encumbered, meaning it is no longer available for pledging in the wider repo and security financing markets. This potentially poses an existential threat to private funding markets, especially in a scenario where almost all bank assets end up being absorbed into central bank facilities.
The G30 report, conscious of this fact, acknowledged that even its lighter-touch proposal poses particular challenges for markets and for the banks active in them, but noted that “the King-Tucker proposal would have a far greater impact on the ability of banks to continue to provide intermediation services between savers and investors” and that “under their model, the banking and financial system would be safer, but almost certainly much smaller.”
To help soothe market stresses, however, there is room under the G30 plan for less liquid assets to be ‘pre-positioned’ first, rather than the ‘high-quality liquid assets’ preferred by the money markets
For now, the pre-positioning regime remains largely voluntary, with banks determining themselves how large an asset book to keep at the central bank. While asset encumbrance is the trade-off, banks remain free to pull those assets out of the system whenever they want.
Were a PFAS regime fully adopted, however, this would no longer be voluntary.
All institutions with short-term runnable liabilities, even non-banks, would be obliged to pre-position enough of their asset book at the central bank to make sure all those liabilities are covered. While that might dispense with the need for deposit insurance or complex liquidity requirement rules, the real question that needs answering is whether it can do so without inadvertently puncturing demand for high-quality assets such as government bonds, or (at the extreme end) crushing free-market capitalism?
Those quoted in the article spoke to Izabella Kaminska while she was representing Politico. Politico’s Geoffrey Smith also contributed.
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