The Financial Crisis and the Product-Mix Auction
In the financial crisis, a new problem faced central banks. Central banks have a role as lender of last resort and from time to time need to provide liquidity to commercial banks and so on.
As Bagehot had described it, the central bank made loans to solvent banks in return for collateral assets. In the past, since solvency implied that the value of assets was at least as great as liabilities, this was a straightforward procedure. However, the 2007 banking crisis[230] was different to what had happened in the previous half century: it was a systemic crisis that affected many banks and was in part triggered by the general uncertainty of some asset values and in particular some assets were held to be toxic (possibly worth very little). Banks had stopped lending to each other because of the uncertainty about the value of each other's balance sheets and required the Bank of England to step in and provide liquidity. The new problem faced by the Bank was how to allocate and price the liquidity provided given that some of the collateral on offer would be less than perfect. As Klemperer described it, after the 2007 Northern Rock bank run: ‘The Bank of England wanted urgently to supply liquidity to banks and was therefore willing to accept a wider-than-usual range of collateral, but it wanted a correspondingly higher interest rate against any weaker collateral it took' (Klemperer 2010a: 526).Paul Klemperer had a solution to the problem. It originated from his belief that auctions could act like markets, and that if you knew what the efficient or desired market outcome looked like, then an auction could be devised to yield the desired market outcome. In this case, the market Klemperer had in mind was one of competitive markets simultaneously clearing for different qualities of asset. He dubbed the auction the Product-Mix auction, the theory of which was written up in a 2008 Nuffield College Working Paper (see Klemperer 2008) and was eventually published in a slightly revised form as “The Product-Mix Auction: A New Auction Design for Differentiated Goods” (Klemperer 2010a).
Banks needed an auction design that was quick to execute and not like the long drawn out 3G licence auction of 2000.Let us assume that the collateral has two standards according to credit rating criteria: strong and weak. Bidders make sets of bids, with each bid specifying a quantity of money to be borrowed from the central bank and two prices, one price (the interest rate the bidder will pay) for each type of collateral the bidder might use. (If the bidder has only one type of collateral available it bids zero on the other type.) These bids make a demand curve for the liquidity supplied by the central bank. There are several banks bidding for liquidity from the central bank, which provides an element of competition. If there were only one bank, it could offer the lowest possible interest rate on just the weakest (worst) collateral. With more than one bank, this unattractive bid will be outbid, even if the other banks are bidding for the other collateral, because the auction decides the prices and quantities, given the bids, in both the strong and weak collateral markets at the same time.
The exact way the central bank decides to do this will depend on its objectives. It may have a fixed supply, or be willing to vary the quantity supplied with the interest rate. Either way, the auction can determine prices for each collateral, and how the supply is allocated across the two markets. The central bank can express its preferences in terms of its supply function: if it is unwilling to accept much weak collateral it can require a premium over the strong collateral that is increasing in the amount of weak collateral accepted.
In the auction, there is only one price for each type of collateral (uniform pricing), as in a competitive market. The central bank chooses a minimum cut off price for each collateral and accepts at most one offer from each bid, with all offers at or above the cut-off paying the cut-off price. Again, this mimics the competitive market where all demand for any good is met at the same price and all those with positive demands above this price get what they ask for (as in a standard competitive market, this is the source of consumer, i.e. bidder, surplus).
If the prices offered for the two collaterals in a bid are both above the cut-off price, the collateral that maximises the bidder's surplus is chosen. Each bidder can make multiple bids.The product-mix auction proved to be a hit with the Bank or England: Governor Mervyn King said that the auction was ‘a marvellous application of theoretical economics to a practical problem of vital importance to financial markets' (King quoted in R.D. 2012). In order to understand the importance of Klemperer's product mix auction one has to consider what the central bank would have done without it. The US Treasury had previously simply fixed either the price (interest rate) or quantity of different types of asset. In this case, it is easy to make a poor choice of price or quantity, since the auctioneer cannot condition on the information that is generated by the bids in Klemperer's design. Klemperer argues that it is best to have a single auction for all products (types of collateral) as it enables the central bank to use all the information to decide how much of each product to allocate. It also means bidders automatically use the collateral that is best for them given the auction prices, whereas they would have to guess which auction was best for them to bid in if the products were sold in separate auctions. The product-mix auction also reduces the market power of bidders as there is competition between buyers across the different products.
The Bank of England went on to develop the product-mix approach: in 2014, it no longer predetermined the total quantity and introduced more than two types of asset. Iceland also planned, and programmed, a version of the auction in 2015, although the plan to use it was dropped in the 2016 political crisis (see Klemperer 2018). Part of the reason for the success of the product-mix auction was that it can be explained in terms of a simple supply and demand figure (for the two asset-type case at least), which was easily understood by policy makers in the central banks.
This was made possible by Klemperer having developed the idea that auctions are a form of market which itself is often easier to understand than what can often be complicated auction theory. This talent for making complex ideas and models simple harks back to his experience in designing allocation mechanisms for the NHS in the late 1970s. Complex models are unlikely to be accepted by policy makers unless they can be explained simply. This is a talent few academic economists possess.In addition, Klemperer developed simple software which could be used to implement his ideas: Product-Mix Auction Software, which is free to use.[231] It includes options for maximising efficiency (the aggregate of the auctioneer's and bidders' profits) or maximising the auctioneer's profits. Also, the software includes the possibility of discriminatory (pay-as-bid) pricing replacing uniform pricing. In the Version for Budget-Constrained Bidders, Klemperer shares the design he developed for the Icelandic government. This version can be applied to situations where a country's creditors exchange their claims (nominal amounts of debt) for a choice among new debt instruments, or an acquired firm's shareholders exchange their holdings (numbers of shares) for a choice of cash or new shares. The software is developed with another of his students, Elizabeth Baldwin.[232]
Klemperer has also worked on auctions in other aspects of public policy. In 2002, he advised the UK government on the world's first auction for greenhouse gas emissions reductions, working with Nobel prize-winner Eric Maskin. He also participated in the meeting that drafted the Potsdam Memorandum to the 2007 UN Climate Change Conference in Bali (see Klemperer 2007, 2010b). Klemperer has also been on the Environmental Economics Academic Panel to the UK's Department of the Environment (Defra).
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