TAF, Fallacy of Composition, Report from Singapore

Author: David Kotok, Post Date: July 8, 2008

Our July 2 commentary about the Fed’s Term Auction Facility (TAF) and banks (see: www.cumber.com ) triggered a banker’s response.  He argued that the 9-basis-point premium that banks paid in the latest TAF auction is justified because of the desire of each bank not to be known as one that borrows at the Discount Window.  The banker was confirming the “stigma” that the market attaches to the use of the Window.

Specifically, he wrote:

“Even a bank on the ropes steered clear of the Window.  The potential reputational cost of using the Discount Window far outweighs the financial savings.  Look at the example above.  9 basis points on $75 billion for 28 days is $630,000.  The most one bank can be is 10% of any TAF, so the cost savings of using the Discount Window over TAF for any one bank was a whopping $63,000 (before taxes).  I’ll pass.

“I don’t get the relationship between the current mess and Discount Window stigma.  The stigma has been there through good times and bad.  If banks collectively as a group decide to override the stigma and use the Discount Window, how does that imply we as a group are not wounded and therefore functional?”

The direct answer to the rhetorical question is “It doesn’t.”  Systemic dysfunction is operating in the US regardless of the use of the TAF or the stigmatized Discount Window.  In fact, the banker reinforces my point and leads the conversation to the Fed’s dilemma.

The Fed is trying to overcome what we call the “fallacy of composition.”  That is the term we use to describe a situation where each agent thinks he is acting in his own rational self interest while the collective actions are counterproductive.  A simple metaphor is a fire in a theater.  Each person wants to get out quickly.  If they collectively do so in an orderly way they can all exit safely.  But if they ignore the orderly process, they create a stampede and some of them get hurt.

The Discount Window was designed to be an orderly process where banks could borrow from the Fed when reserves were needed during dysfunctional times.  That characteristic created the stigma.  To try and remove this sign of failure, the Fed actually came out and stated there was no stigma.  Clearly no one believed it. 

The Fed then tried to demonstrate this with a request that certain banks use the Window to show there was no stigma.  Four large banks did use the Window for a short time.  They then withdrew.  So much for the Fed’s request!  That approach failed, too. 

During the recent financial turmoil the Fed has lowered the Discount Window borrowing rate by a greater amount than it lowered the Federal Funds Rate.  And the Fed has liberalized the collateral it will accept.

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