One of the main achievements of the on-going global financial crisis is its sharp focus on ‘the lender of last resort function’ of central banks. Starting with the US Federal Reserve, central banks across the world have now turned into the ultimate backstop for liquidity support in the financial system.

Given the size and complexity of the US financial system and also given the fact that the crisis originated in the US, the Fed has left no stone unturned in its wide ranging efforts to provide liquidity support. Not only has the US central bank expanded the range of financial assets it will accept as collateral for its financial support; it is also providing the support at extremely low interest rates. Going further, the US central bank has also intervened directly in the commercial paper market for non-financial companies.

Necessity is the mother of invention and adversity justifies an unorthodox problem-solving approach. That seems to be the guiding principle for the Fed's actions. Indeed, this is no time for policy purists who may be shocked by the fact that much of the assets the Fed is now re-financing at low interest rates are not top quality or even investment grade. The textbook prescription is for central banks to provide liquidity support against high quality collateral at a penal interest rate. The Fed has been indicating that the present is certainly no time for such a text book approach.

Nearer home, the Reserve Bank of India too has put together a number of schemes in the past couple of months to enhance liquidity support to a range of financial market participants - be it commercial banks, mutual funds or non-bank finance companies.

Lender of last resort, a natural role but broader signals

To be sure, central banks being called upon to perform their role of lender of last resort should not come as a total surprise. Indeed, the very integrity of the concepts of paper / fiat money, fractional reserve banking and financial assets is dependent on market participants having and retaining trust in the value of paper money and the financial claims / assets created by the system of reserve banking / financial intermediation. This implies that at some point in time when there is a breakdown of trust in such paper assets, it is inevitable for the central bank, to step in and be the buyer / lender of last resort to re-create that trust. Central banks, therefore, have now undertaken a role naturally expected of them.

The implications of such wide ranging central bank intervention to provide liquidity support to the financial system / broader economy though are not very clear at the moment. Indeed, the on-going global financial crisis has been the first instance, in the modern era, of almost all global central banks being called upon to perform their lender of last resort role simultaneously. It is an international effort now as compared to country-specific actions in earlier episodes. This means an enormous amount of fresh liquidity is being created (to put it more bluntly, the currency printing presses are now working feverishly overtime everywhere) across all major economies. It is quite possible that all this liquidity ends up fanning a fresh bout of asset bubbles and inflation a couple of years from now.

Of course, prospective asset bubbles and inflation does not seem to be much of a concern now, given the focus on crisis management and getting the wheels of credit and finance to move again.

Nevertheless, central banks stepping into a direct supporting role in the financial system and buying large amounts of financial assets highlights some broader issues relating to the financial markets and financial instruments.

Illiquidity in debt markets gets highlighted

In the Indian case, for example, the illiquid nature of our debt markets has been sharply highlighted by the poor response to the schemes the RBI has designed (referred to above) for providing liquidity support. Against the RBI's readiness to provide liquidity support for up to a cumulative Rs.60,000 crore to commercial banks - which in turn can be utilized by banks to provide liquidity to mutual funds and non-bank finance companies - just about 10 per cent has been utilised (as of 18 November) in the 2 months the scheme has been in operation. (The RBI has also said that the scheme would continue to operate till March 2009).

The poor utilization of the RBI's liquidity support window is certainly not because mutual funds / non-bank finance companies do not require liquidity support at the current juncture.

Indeed, the redemption pressures and near crisis attending the debt mutual funds (with exposures to real estate-linked fixed income instruments) in recent weeks have shown that debt mutual funds are desperate for liquidity. They have not been able to utilise the liquidity support window through the commercial banks because their investments in the debt paper of commercial banks (that is, certificates of deposit of commercial banks) is very limited, in relation to the size of their total corpus. Most of their investments is in non-bank debt instruments which obviously cannot be redeemed or refinanced by banks.

Therefore, here is a situation where the central bank is ready to provide liquidity support but it cannot reach mutual funds because the funds do not hold financial claims on the commercial banks through whom the (liquidity) support has to be intermediated.

Is the next step, then, for the RBI to enter the market and buy out the illiquid investments directly from the mutual funds? Why would or rather should it end only with the mutual funds? Illiquidity plagues the fixed-income portfolios of other financial market participants such as the insurance companies also. Would not a central bank move to rid the market of illiquid assets extend to such firms also?

An aggravation of the financial crisis could well result in such a decision by the government / RBI. To be sure, the US Fed can always be cited as the prime example of a Central bank intervening directly to provide liquidity support even to non-bank market participants. The only, but serious, bugbear in such an eventuality, as pointed out already, will be its inflation consequences.

If only debt markets were more liquid…

National policy makers, in this environment, could well be ruing the high illiquidity which plagues the Indian debt markets - both the government and non-government bond segments. As indicated above, an exacerbation of the overall crisis could well compel the Indian authorities also (like the US Fed) to open the liquidity tap even more directly by buying into private sector debt. The inherent illiquidity of the Indian debt market would be really exposed in such an environment, potentially throttling and freezing the flow of credit and finance in the financial system, necessitating direct central bank action.

Less than 0.5 per cent of the total stock of outstanding private sector debt (of around Rs.5 lakh crore) gets traded on an average day in the Indian markets. The government bond markets - with average daily secondary market turnover of less than 1 per cent of outstanding government debt of around Rs.19 lakh crore - are not much better off. An additional concern with the government bond market is the concentration of liquidity in just 2 or 3 securities at any point in time.

The on-going financial markets crisis should, therefore, trigger a major reform effort to energise the Indian debt markets. Broadening the primary issuer base, widening the investor base, undertaking such taxation and legal measures relating to stamp duties and the tax treatment of debt instruments as would eliminate the disincentives for secondary market trading, developing a system of market-makers and building efficient trading, trade reporting, clearing and settlement systems - these are some of the critical steps required to kick-start the Indian debt markets.

Fortunately (or unfortunately given that progress on this front has been limited) Indian policymakers have a blue print for debt market reforms ready - the Dr. R.H. Patil Committee report of 2005. No further time should be lost in implementing the report's recommendations. What else can be a catalyst for reforms in this area than the crisis of 2007/2008?