$500 billion reserve drain made crisis worse: IMF’s Ferhani

Central banks' reserve managers exacerbated the global liquidity crunch as they drew down half a trillion dollars on deposit at banks after the crisis struck, a senior IMF official said on Friday.

Speaking at Central Banking's National Asset Liability Management conference in London on Friday, Hervé Ferhani, the deputy director of the monetary and capital markets department, said: "By and large, reserve managers reduced their exposure to risk assets in a way that was similar to the behaviour of commercial fund managers. A forthcoming working paper by the IMF estimates central bank reserve mangers moved approximately $500 billion out of bank deposits during the crisis."

The sum withdrawn is equivalent to just over 7% of global foreign exchange reserves as of end-July 2009 according to IMF data. While surveys carried out by Central Banking Publications in 2008 had shown how reserve managers had reduced credit exposure, raised credit limits and cut counterparties during the crisis, the IMF has provided the first estimate of the financial impact of such retrenchment.

In moving with the herd, some central banks added to the intensity of the crisis, Ferhani said. "From a risk return perspective, I believe that this collectively may have exacerbated the liquidity problems of the private sector during the crisis. Or put slightly differently, forced other authorities to act more forcefully in their effort to solve the crisis."

He noted that the European Central Bank (ECB) had to take extraordinary measures to provide liquidity, even though the crisis did not start in Europe. In acting as a contrarian they could ironically see an improved performance, he noted. "The Fed and the ECB have made handsome returns, but it is not difficult to envision a situation in which they make a loss," he said.

Ferhani blamed reserve managers' procyclical behaviour on a search for yield, which started in the 1980s but had intensified in the last decade. Central banks had traditionally invest their foreign exchange reserves in high-quality sovereign debt or short-term deposits in banks, but this changed he said. "Central banks around the world began to invest in assets with higher return. To the outside world this was presented as diversification. But diversification is commonly associated with risk reduction. Instead, the change in the composition of reserves reflected above all the search for yield," he said.

"Central banks moved out of treasury bills and into securities with more credit, repayment and liquidity risk and with longer maturities. An increasing amount was deposited in commercial banks. For several years reserve managers enjoyed higher yields and capital gains. But in the crisis, liquidity fell and spreads widened."

Post crisis, Ferhani urged reserve managers to follow countercyclical investment strategies. "Diversification deserves a thorough review. You have to have sufficient confidence in an asset to hold it to maturity. And, if not, then you shouldn't buy it," he said. "Reserves management needs to be less adventurous in normal times, but more so in times of crisis. The official sector must lead by example."