Risk endogeneity at the lender/investor-of-last-resort

Summary

Focus

We address to what extent a central bank can de-risk its balance sheet through unconventional monetary policy operations. To that end, we propose a novel risk measurement framework to empirically study the time variation in central bank portfolio credit risks associated with such operations.

Contribution

For at least 150 years, going back to early contributions such as Thornton (1802) and Bagehot (1873), central bankers have wondered to what extent they make rather than take their own balance sheet risks during turbulent times. Theoretically, the possibility of the central bank influencing its own risk is uncontroversial. In the context of a pure illiquidity crisis without solvency concerns, for example, the simple offer by the central bank to act as a lender of last resort to the entire financial system in line with Bagehot-inspired principles could shift the economy from a "bad" to a "good" equilibrium, causing all illiquidity-related credit risks to quickly disappear at virtually no cost or additional central bank balance sheet risk. We study whether such a possibility is wishful thinking or empirically relevant.

Findings

We focus on three main findings. First, we find that lender of last resort- and investor of last resort-implied credit risks were usually negatively related in Eurosystem data between 2009 and 2015. Taking risk in one part of the central bank's balance sheet tended to de-risk other positions. This negative relationship implies that, overall, central bank risks can be non-linear in exposures. Second, some unconventional policy operations did not add risk to the Eurosystem's balance sheet in net terms, in line with Bagehot's well known assertion that, in some situations, "only the brave plan is the safe plan". Finally, our risk estimates suggest that the Eurosystem's unconventional monetary policies differed in terms of ex post "risk efficiency".

Abstract

We address to what extent a central bank can de-risk its balance sheet by unconventional monetary policy operations. To that end, we propose a novel risk measurement framework to empirically study the time variation in central bank portfolio credit risks associated with such operations. The framework accommodates a large number of bank and sovereign counterparties, joint tail dependence, skewness, and time-varying dependence parameters. In an application to selected items from the consolidated Eurosystem's weekly balance sheet between 2009 and 2015, we find that unconventional monetary policy operations generated beneficial risk spillovers across monetary policy operations, causing overall risk to be non-linear in exposures. Some policy operations reduced rather than increased overall risk.

JEL classification: G21, C33

Keywords: credit risk, risk measurement, central bank, lender-of-last-resort, unconventional monetary policy