Predatory trading, Stigma and the Fed׳s Term Auction Facility

Abstract

Predatory trading may affect the incentives for banks to raise liquidity in times of financial distress. In these periods, borrowing becomes a signal of illiquidity, exposing borrowers to predatory trading and possible insolvency. A stigma of borrowing thus arises, leading distressed banks to take on more illiquid positions than they would otherwise. The Fed׳s Term Auction Facility (TAF) can alleviate this problem. The TAF׳s competitive auction format allows auction winners to signal that they are illiquid but relatively strong. The TAF may therefore be an effective policy tool during financial crises: by altering the signal value of borrowing, this facility supports the injection of liquidity into distressed banks. In normal times, however, this auction facility becomes counterproductive: by cream-skimming the relatively strong banks, the weakest banks are left as potential prey for predators. This suggests that the TAF is a policy best reserved for times of crisis.