Demand wanes for central bank liquidity schemes

The European Central Bank (ECB) has witnessed the sharpest decline in demand. Out of a possible $100 billion of one-month bonds auctioned on November 18, the ECB only received applications for $4.8 billion from four bidders, a bid/cover ratio of 0.05. In comparison, on September 22, propositions for $82.1 billion from 48 bidders outweighed the $40 billion available, a bid/cover ratio of 2.05.

In the UK, interest in the Bank of England's overnight dollar repo operation has also diminished. On September 25, the bid/cover ratio was 0.63, with submissions for $35 billion out of a possible $40 billion. By comparison, November 7 saw a bid/cover ratio of 0.03 as only $250 million out of a possible $10 billion was applied for.

Similar results were apparent in the Bank's three-month repo operation. On October 7, the first auction after the Bank loosened collateral restrictions, it received bids for £30.7 billion out of a possible £40 billion, a bid/cover ratio of 0.77. But on November 18, bids received amounted to £7.1 billion out of a possible £20 billion, a bid/cover ratio of 0.36.

The US Federal Reserve's Term Auction Facility (TAF) has also issued fewer loans. On November 17, TAF accepted $104.5 billion worth of propositions from 80 bidders, a bid/cover ratio of 0.7 (there was a total of $150 billion on offer). This contrasts with a bid/cover ratio of 1.77 the week after the collapse of Lehman Brothers, when propositions from 85 bidders totalled $133.6 billion, greatly exceeding the $75 billion on offer.

Analysts at Economy.com, a subsidiary of ratings agency Moody's, said that several factors explain the falling demand.

"The Fed has created several lending facilities so that banks have an array of options to borrow from," said Ryan Sweet, senior economist at Economy.com's US office. "[It is] meeting the liquidity needs of the financial system".

Sweet believes the Fed has become better at anticipating what each auction needs to provide, reducing excessive demand for individual auctions. He said the size of the auctions is likely to remain the same until lending markets are well on their way to recovery.

"It's also reflecting banks' reluctance to lend at the moment," commented Ruth Stroppiana, chief international economist at Economy.com. "Their demand for funds probably isn't as great as it was a few months ago. Also, as we draw closer to the end of the calendar year, banks are increasingly shoring up their balance sheets to meet internal year-end targets."

The interbank lending market has also showed some signs of recovery, and this will also have reduced demand for central bank loans - the Ted spread, which measures perceived counterparty risk by tracking the difference between three-month dollar Libor and US Treasury bills, peaked at a record high of 4.64% on October, but has since fallen, standing at 2.14% yesterday. However, this still represents a high level of perceived interbank risk by historical standards. The Ted spread has historically maintained a level of around 30 basis points; before August last year it had not breached the 1% threshold since 2001. Cuts in central bank interest rates have also helped ease interbank lending, Sweet said.

The TAF was launched in December 2007 amid worsening liquidity conditions to provide banks with short term funding. A specific range of collateral could be exchanged in return for a fixed term loan. At first, auctions were substantially oversubscribed; on December 17, the bid/cover ratio was 3.08.

The Bank of England followed suit in April this year, establishing its own Special Liquidity Scheme. The ECB chose to expand existing schemes rather than create a new one.

As the financial crisis deepened, central banks increased the amount of capital available to banks and began to accept a broader range of collateral to counteract the freeze in interbank markets following the collapse of Lehman Brothers.

See also: Fed to treble lending
TAF auctions hint at liquidity improvement
Fed ramps up bank support to $75 billion

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