Credit Auctions

Use of Central Bank Credit Auctions in Economies in Transition

Auctions or tenders are used as means of allocating portions of central bank credit in many industrial and developing countries.

In a number of economies in transition from centrally planned to market-based systems, the central banks have begun to use credit auctions as part of broader packages of reforms to foster market-based monetary operations, promote money markets, and improve monetary control.

However, while the monetary operations of central banks in market economies are supported by well-functioning interbank markets, adequate risk management—including the use of collateral—and effective banking supervision, these factors may be insufficiently developed in economies in transition.

Credit Auctions as an Alternative to Administrative Allocation

In most planned economies, credit was allocated administratively to specific sectors or borrowers at preannounced interest rates.

The main disadvantages of this approach are that the use of directed credit is prone to misuse and abuse, the pricing of credit may be inefficient, and administrative allocation procedures tend to favor the state-owned sector and do not lay a foundation for more market-oriented financial systems.

An auction-based allocation system can allocate credit transparently, based on objective criteria. In the absence of distortions, auction-based allocation mechanisms function efficiently; that is, they ensure that resources accrue to those that value them most highly and where they will be most productive (Feldman and Mehra, 1993). Furthermore, an auction-based system introduces market interactions and price flexibility, which can form a basis for further financial sector development.

When no restrictions are placed on the use of auctioned credit and on the interest rate in the auction, and when banks act rationally to maximize profits, central bank credit is expected to flow to banks that can make the best use of the available resources.

Since the end use of funds will be determined by the commercial banks, the government will no longer be presumed to guarantee banks’ loans, and banks will be forced to develop their credit analysis capabilities.

State-owned enterprises will be forced to compete with other bank customers in terms of both price (loan interest and expected project rate of return) and quality (reliability of returns). Furthermore, credit auctions can be an important component of the package of measures needed to liberalize and manage interest rates and improve monetary control in economies in transition.

Regularly scheduled auctions introduce a market-based reference lending rate that can influence and guide the market as well as other central bank operations. Moreover, the central bank can control the volume of credit auctioned, taking into account other factors that affect bank reserves, and thereby influence either the level of bank reserves or the interest rate in the auction and in the interbank market.

By introducing a flexible-price market in bank liquidity, auctions contribute to the development of the interbank money market and thereby pave the way for strengthening indirect instruments and phasing out any direct controls on credit and interest rates.

Early introduction of credit auctions allows the central bank to gain experience in market-based monetary control and, as money markets develop, sets the stage for more sophisticated open market operations. As banks learn to assess liquidity conditions and price credit through participation in the auction, they will become more active in managing their reserve positions, thereby stimulating money market dealing.

Furthermore, imposing uniform and transparent access to credit will force banks that have historically been supplied by directed central bank credit to look at other sources including the interbank market. However, some of the assumptions underlying the expected efficiency of an auction-based system may not apply in economies in transition.

Possible impediments to the use of uncollateralized credit auctions in these economies involve deficiencies in incentives and information, which can increase the credit risk to the central bank and compromise the allocational efficiency of the auction mechanism.

Credit risk may result from adverse selection—the tendency to attract banks willing to offer the highest bids but bearing the highest risks; and from moral hazard—the inability of the central bank to influence or monitor how the borrowing bank uses the funds.

These problems could be more significant in economies in transition, where some banks may be insolvent, the banking system as a whole may not be competitive, banks’ accounting and reporting are insufficiently developed, and banks’ weak portfolios induce an inelastic demand for central bank credit, than in countries that use collateralized credit auctions in the context of well-developed banking systems and financial markets.

Thus, there are potential advantages and disadvantages to using an auction mechanism for the allocation of credit in economies in transition.

The next section will discuss how auctions can be designed to minimize the problems of adverse selection, moral hazard, and collusion.

Design of Auctions to Control Credit Risk

Adverse selection and moral hazard may be addressed by requiring adequate collateral, formulating appropriate access rules for the auction, and setting limits on the volume of central bank credit that each bank is allowed to borrow.

Ideally, central bank lending should be collateralized by government securities or other high-quality paper, but in economies in transition, banks’ securities holdings are often negligible, particularly in the early stages of reform. In these circumstances, the collateral requirement can be introduced only gradually.

Since a program to develop treasury bills and other securities is typically part of the transition strategy, some requirement of collateral is feasible and desirable even if it covers less than 100 percent of the loan. In addition, the range of admissible collateral can be broadened to include such assets as foreign exchange and banker’s acceptances.

As the volume of treasury bills and government securities in the market increases, the rate of collateralization can be increased, gradually transforming the uncollateralized credit auctions into a repurchase auction.

They must be uniform and transparent and should include compliance with all mandatory prudential ratios, including:

Even under uniform and transparent access rules, current uncertainties underlying the computation of prudential ratios may temporarily limit the effectiveness of these ratios in screening banks. In addition to access rules, credit limits as a ratio (or multiple) of each bank’s deposits or capital could be set.

Whereas setting a limit in relation to deposits might encourage banks to compete for deposit resources in the market, a limit in relation to a bank’s capital might encourage prudent behavior. However, there is a trade-off between regulation and competition. The need to limit central bank credit risk must be balanced against the need to ensure fairly wide access by banks so as to permit adequate competition at the auction.

In many countries, the auctioneer retains the right to screen bids and reject any that are deemed inappropriate. However, the option to reject a bid must be exercised judiciously to avoid diminishing confidence in the fairness of the auction or interfering with the price discovery function of the auction.

Frequently, central banks set a minimum auction rate to increase monetary control, discourage recourse to central bank lending, or coordinate the auction with other central bank facilities. Setting a floor below the interest rate could also prevent banks from colluding to bid a low interest rate.

However, announcing the minimum rate in advance provides a focal point for collusive bidding. Even if the minimum rate is not announced, participants may guess the level and their bids may cluster around the assumed minimum rate. Although this outcome may appear to demonstrate collusive behavior, widespread bidding at the minimum rate may also indicate that there is liquidity at the floor price.

While the best insurance against collusion and uncompetitive behavior is a dynamic and competitive banking sector, some auction procedures may reduce the likelihood that collusive arrangements can be sustained. These include using sealed bids rather than an open outcry mechanism; awarding credit at a uniform price; limiting the postauction sharing of information with bidders; and limiting the share of total volume offered for which any one bank may bid (see Feldman and Mehra, 1993; Guasch and Glaessner, 1993).

Ultimately, the design of an auction cannot insure against all risks, from both the credit risk and monetary control perspectives. Credit auctions are typically initiated on a small scale, allowing central banks to gain experience in monitoring borrower behavior in conditions of limited total risk. In any event, the likely alternative—administratively allocated credit—cannot control for these risks either.

Economies in transition have long records of nonrepayment of directed credit. Administered allocation of credit led to outstanding loans being serviced through additional directed credit, a form of adverse selection in that the borrowers were those who could not repay previous loans.

In the early stages of transition, assets in the portfolios of the newly created commercial banks were largely loans carried over from the previous systems of administrative allocation; of these assets, nonperforming loans were estimated at 15–20 percent in Czechoslovakia and Hungary, 20–30 percent in Poland, and 40 percent in Bulgaria (Calvo and Kumar, 1993).

Clearly, credit risk is significant under administrative allocation. Furthermore, the potential for collusion between enterprises, banks, and officials may be worse under a system that explicitly allows discretionary allocation than under a rules-based auction.