Stigma in Financial Markets Discussion by Lucy White Harvard Business School and CEPR

The Environment From December 2007, banks can borrow from the Federal Reserve via: The Discount Window (DW) The Term Auction Facility (TAF) Prior to 2003, DW lending was at rates below market and if all other funding sources had been exhausted. Post 2003, a 100 basis point penalty was introduced (reduced to 50 Aug 2007), and lending restricted to generally sound institutions “to reduce stigma”.

Comparison of TAF and DW lending Same collateral and same institutions have access as to DW. TAF = bi-weekly auction of funds for either 28 or 84 days. DW loan terms extended up to 30 days (Aug 2007) and 84 days (March 2008), can be prepaid. DW is a posted price (fed funds rate plus penalty) whereas TAF is a uniform price auction where bidders submit a 1-or-2 step demand curve with a reserve price. Cannot prepay. Can bid for up to 10% of allocation.

Comparison of TAF and DW lending It would also be useful to know something about information released about who borrows from the DW and who borrows from the TAF. Are these in principle the same (i.e. secret)? This seems to be important.

The Hypothesis: Stigma associated with DW DW offers almost the same thing but more flexibly, so for the same price, choose that? Suggests that if banks bid for funds at prices higher than the DW rate in the TAF, they must be doing so because they fear some kind of stigma associated with DW borrowing. Paper will test whether indeed banks bid for funds in TAF at rates higher than what they would pay in DW.

A Preliminary What are you thinking of as being the source of the stigma? Is it just a “sunspot”? Or is it “rational” in the sense that the institutions that actually do borrow from the DW are worse in some sense, so that there is a signal in going to the DW?

First Test Check the difference between each bank’s highest bid in the TAF and the DW price. For those banks where the difference is positive, we say that these banks face a stigma from borrowing from the DW. The maximum potential stigma and the actual realised stigma can be calculated. Note that by construction, the amount of stigma is always positive. Would it be fairer to also include banks which bid below the DW?

Aside: The Rationality of Bidding above the DW price at the TAF Argument: the TAF is almost like a standard uniform price auction where it is a dominant strategy to bid your WTP, and here WTP should be less than or equal to what you would pay for essentially the same thing at the DW. Idea: either your bid is not marginal, in which case “it makes no difference” or it is, in which case, if you bid more than your WTP, you will pay your bid and lose money.

Aside: The Rationality of Bidding above the DW price at the TAF Small caveat: This is a multi-unit uniform price auction where moreover you can bid a 2-step demand curve, so bidding your willingness to pay is not a dominant strategy. Infra-marginal bids will affect who is the marginal bidder. The standard strategy in such auctions would be demand reduction to try to reduce the market-clearing price. However, this tends to suggest that one should bid below the DW price rather than above it, reinforcing your results.

Result Figure 4: Dec 07-Mar 08, few banks bid above DW rate. Post March 16 reduction in penalty rate, more than 60% of banks do so. Banks which did this tended to do it regularly, but the result seems too widespread for it to be simply persistent stupidity on the part of a few banks.

What affects the extent of DW stigma? Small banks more likely to exhibit it. (Naïve bidding by small banks?) Seems to be worse when market conditions tighter – counter-intuitive: would think that more banks would use the DW when it is commonly known that conditions are otherwise tight as the adverse signal from failure to get funds elsewhere should be less.

Rising share of banks bid above DW rate

What affects the extent of DW stigma? Banks that used the DW in the previous week are less likely to bid above the DW rate: two interpretations – either they are already stigmatized so it doesn’t matter OR they are rational and know that they can accessing cheaper funds through the DW, and bid accordingly. Do some banks borrow from both DW and TAF? Stigma seems to get worse when more banks accessed the DW last week – contrary to what wd be expected (is this market conditions or a selection effect?).

What affects the size of DW stigma? Similar results as for the extent of the stigma except that no jump in March 2008: stigma shrinks with size, and (counter-intuitively) grows with worsening market conditions.

How much does this behaviour cost the banks? Take each bank which bid above the DW rate and imagine: That the bank had paid their maximum bid in every auction in which they had participated. How much extra would it have paid on average? Answer: $0.43m per auction, or a 12.3% increase in interest costs. How much extra did it actually pay? $0.25m per auction or a 9.1% increase in interest cost.

How do markets react to DW borrowing? Significant negative impact of DW visit on overnight interbank borrowing rate on day of DW visit, partially but not completely reversed in following 3 days. No effect on CDS rates. Stock return declines on day it visits DW, again partially reversed. Is there are a concern about the direction of causality?

Other possible explanations? Could there be an element of “precautionary bidding”? No. On occasions when TAF is offering a longer term, this might provide a motive for bidding more there. Are ceilings on bids ever binding (so banks would want to bid in both)?

Implications for LOLR design? Lowering the penalty rate seems to make things worse. TAF and DW are both “borrowing from the government and not the market”. Why should one have more stigma than the other? Just a “sunspot”? TAF design implies that at least 9 other banks are doing the same as you? If TAF and DW are so similar, does it matter if banks avoid one as long as they use the other?

Summary Convincing evidence that banks avoid the DW in favour of the more expensive TAF alternative. Open question: what, if anything, could or should be done about this?