Reflecting Trichet

A speech by Jean-Claude Trichet at the International Capital Market Association’s Annual Conference has received considerable comment - see here for instance for Alea. I'd like to focus on just two aspects in a long speech. First, leverage:

The challenge lies in preventing the system from feeding on itself through a spiralling process of leveraging...

Abundant liquidity, financial complexity [and] financial players’ incentive structures contrived a convergence of mechanisms that resulted in the upward spiralling of asset prices, further leveraging, increasing complexity and shrinking transparency.

The combination of leverage and complexity is a massive concentrator of model risk. Simple leverage is easy to spot: my broker won't let me buy stock on margin with a 1% haircut. But a tranche of a CDO-squared financed via repo could have a much higher leverage than 100:1. Complexity, then, can hide leverage and it can make modeling the true return distribution difficult or impossible: just because you can structure something does not mean that you should, as Bankers' Trust found out with Gibson's Greetings and Libor-squared swaps.

Second, ECB open market operations:

The first response of the Eurosystem during the turmoil was to try to keep very short-term money market rates near policy rates through more active liquidity management. With this objective in mind, the ECB adjusted the distribution of liquidity supply over the course of a maintenance period, by increasing the supply at the beginning of the period and reducing it later in the period (the so-called frontloading). The average supply of liquidity remained unchanged over the whole reserve maintenance period, in line with the Eurosystem’s aim to provide to the banking system over each maintenance period the exact amount of total liquidity it needs to fulfil its liquidity deficit. The average size of the Eurosystem’s refinancing operations for the maintenance periods since August 2007 remained at around €450 billion, as in the first semester of 2007.

This is remarkable -- and it makes the point beautifully that is is not the supply of cash that has been important in central bank financing operations, but rather guaranteed funding for illiquid assets. The ECB has indeed been remarkably liberal (by the standards of other central banks pre Crunch) in the collateral it permits at the window, and so it did not need to explicitly manipulate liquidity premiums the way the FED did.