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April 05, 2008
The Power of Central Bank Communications
In Chris Whalen's interesting blog ( April 4,2008) on the Subprime crisishttp://www.prmia.org/Weblogs/Regulation/ChristopherWhalen2/)
, a few lines are particularly interesting :
"As BSC was being shut out of the interdealer market, LEH was also being shunned by other dealers and attacked by the hedge fund hordes in the same fashion as BSC. Several veteran traders in the CDS market say that LEH was essentially in danger of failing as well.
One hedge fund veteran, who was and is short LEH, complains to The IRA that LEH was essentially dead in the water on Monday, March 17, but the Fed intervened. When the markets opened after the Easter holiday, clients and other dealers were backing away from LEH and the shorts were swarming in for the kill, he claims. This apparently explains the unusually long conference call with investors by LEH CFO Erin Callan, who has only held that position since September.
Indeed, the only reason that LEH did not fail as well, claims this well-connected trader, was a conference call on that Monday with the top ten dealers organized by the Fed of New York. During that call, the Fed of New York reportedly told the other dealers that it would lend LEH "whatever is necessary" to keep that leading mortgage-backed security underwriter and CDS house afloat. That open-ended promise, not the Fed's new lending facility, reportedly saved LEH from collapse - for now."
This open ended promise, is nothing but an increasingly powerful instrument in the hands of Central Banks, its signaling policy. A credible central bank, through the use of the media, can effectively and quickly transmit signals in the market.This obvious and very promising tool , which can be used (and abused), is not adequately researched in the context of financial regulation. The academic research, however, dates back a few decades. Jurgen Habermas' critical theory of law is essentially based on the argument that communication channels can be used to reform law and it need not always be driven by official dictat, as Max Weber had earlier suggested. In one of his later accounts of this power of communication, Habermas wrote about the "liberating power of symbols", where communication creates symbols that travels through media, changes public mind and as a result , transforms policy.
In the framework of financial regulation, the framework of central bank's communication policy is less clear, but is getting increasing academic attention as central banks transcend their traditional focus of monetary policy and focus more on financial stability.
Several issues have come to the fore in the context of signaling by the central banks with focus on four key aspects of policy, namely,
efficiency, time-consistency, optimality of communications, and institutional decision making processes. Efficiency issues centre around quality, formation of expectations, and implementation lags. The time-consistency issues relate to the conditions for substitutability between communications and policy actions, and choices between effectiveness of unanticipated policies relative to elimination of uncertainty in private decision making. The optimality
issues address the aspects of dangers of disseminating information which could result in crowding out of the formulation of independent beliefs by the privatesector – which is critical to well-functioning markets.
While dealing with this sensitive areas of regulatory intervention through communications, several questions come to the fore.
First, what should be the optimal content of such communications?
Second, will such communication have the same impact on all segments of society, including financial markets, media and general public?
Third, at what stage of internal debate the communication should take place?
Fourth, how to ensure that communication is timely enough to prevent panic or disasters in the market?
Fifth, should there be a clear line of agreed course of action, with clearly demarkated lines of responsibilities ensuring transperancy and removing conflicts of interests, if any?
Quite clearly, central bank communications in today's world have gone far beyond annual reports and periodic monetary policy assertions. Assurances over Conference Calls can produce the desired impact on the financial markets. While more research in this area is clearly desirable, one can be reasonably confident that such issues are likely to gain prominence in future as Central Banks all over the world try to deal with volatile , interlinked global financial markets.
Posted by sunandoroy at April 5, 2008 05:24 AM
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