Central bank funding reduces private costs, stimulates credit
A new Bank for International Settlements working paper finds that central bank funding schemes primarily reduce private wholesale funding costs, stimulating credit supply. Banks more exposed to stress in private markets use less central bank funding directly, benefiting from the mere availability of public liquidity.
The liquidity paradox: Less use, more impact
Contrary to the notion that public liquidity is primarily a substitute for private liquidity, the study reveals a 'liquidity paradox'.
Banks more exposed to stress in private wholesale funding markets actually use less central bank funding directly.
The mere availability of central bank funding, however, reduces the cost of private wholesale funding, stimulating lending regardless of direct usage.
This 'equilibrium effect' is the dominant channel, particularly for large banks, leading to significant reductions in mortgage spreads.
For instance, a bank with 32 percent wholesale funding reliance reduced mortgage spreads by 68 basis points after the FLS announcement via this effect, outweighing direct participation benefits.
The effect operates through a reduction in perceived bank funding risk, rather than increased bargaining power.
BoE's FLS: Conditional funding and its impact
The research exploits the Bank of England's Funding for Lending Scheme (FLS), launched in June 2012 during the euro area crisis when UK banks faced high wholesale funding costs.
The FLS offered four-year loans, conditional on banks' lending to households and firms – a design later adopted by the European Central Bank's Targeted Long-Term Refinancing Operations (TLTROs).
Crucially, the FLS announcement did not coincide with other major policy changes, enabling clearer identification of its effects.
The paper also leverages subsequent surprise amendments to the scheme's terms, particularly regarding FLS2 in April and November 2013, to analyze how 'strings attached' to central bank funding affect credit supply.
This allowed for testing the non-pecuniary costs associated with conditional public liquidity versus unconditional funding.
Rethinking central bank effectiveness
This research fundamentally shifts how we view central bank liquidity operations.
It highlights that the mere presence of a backstop can be more impactful than direct usage, challenging traditional metrics like take-up rates.
For policymakers, this implies a need to focus on market perception and scheme design, rather than just the volume of funds disbursed.