Summer Rerun: Martin Wolf: Banks Hold Central Bankers Hostage

This post first appeared on September 21, 2007

In an intriguing article today, “The Bank loses a game of chicken,” Martin Wolf, the Financial Times’ chief economics writer, followed the lead of the Bank of England’s Governor Mervyn King in backing down from their shared view that central bankers should be willing to let all but those banks “too big to fail” go under.

For those who have somehow missed this saga, King in a submission to Parliament last week reiterated a very tough stand on the principle that banks should bear the consequences of their bad decisions unless their collapse posed a systemic threat. A mere two days later, the Bank of England, in a joint decision (as prescribed) with the Treasury and the FSA, organized a rescue of the number five building society, Northern Rock. Northern Rock was clearly too small to pose a threat to the financial system, and there was a hue and cry as a result of King’s abrupt reversal.

Wolf argues that commercial banks have the upper hand in any showdown where a bank is at risk of failure. He is clearly distressed at this asymmetry; bank investors profit in good times yet can socialise their risks when conditions become adverse. Wolf goes as far to call for nationalization (in context, it isn’t clear whether he was calling for nationalization of the banking system or of Northern Rock alone).

UCSD economist James Hamilton made a similar observation about how, push come to shove, central bankers have to relent even if the risk of moral hazard is real. While he was talking about Fannie Mae and Freddie Mac in his presentation at the Fed’s conference at Jackson Hole, his reasoning has broader application:

The concern that I think we should be having about the current situation arises from the same economic principles as a classic bank run…. The problem arises when the losses on the institution’s assets exceed its net equity. Short-term creditors then all have an incentive to be the first one to get their money out. If the creditors are unsure which institutions are solvent and which are not, the result of their collective actions may be to force some otherwise sound institutions to liquidate their assets at unfavorable terms, causing an otherwise solvent institution to become insolvent….

This acquisition of mortgages was enabled by issuance of debt by the GSEs which currently amounts to about $1.5 trillion. Investors were willing to lend this money to Fannie and Freddie at terms more favorable than are available to other private companies, despite the fact that the net equity of the enterprises– about $70 billion last year– represents only 5% of their debt and only 1.5% of their combined debt plus mortgage guarantees. If I knew why investors were so willing to lend to the GSEs at such favorable terms, I think we’d have at least part of the answer to the puzzle.

And I think the obvious answer is that investors were happy to lend to the GSEs because they thought that, despite the absence of explicit government guarantees, in practice the government would never allow them to default. And which part of the government is supposed to ensure this, exactly? The Federal Reserve comes to mind. I’m thinking that there exists a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default. The creditors may have reasoned, “the Fed would never allow aggregate conditions to come to a point where Fannie or Freddie actually default.” And the Fed says, “oh yes we would.” And the market says, “oh no you wouldn’t.”

It’s a game of chicken. And one thing that’s very clear to me is that this is not a game that the Fed wants to play, because the risk-takers are holding the ace card, which is the fact that, truth be told, the Fed does not want to see the GSEs default. None of us do.

Wolf explains how even a second-tier institution like Northern Rock in effect became too big to fail.

Wolf is clearly frustrated with the current regulatory regime which allows banks to enjoy the upside while being able to have taxpayers take the downside risk. But there are solutions other than simply nationalizing banks. For example, after the savings and loan crisis, McKinsey partner Lowell Bryan called for banks to hold risk free assets like Treasuries in the same amount as guaranteed deposits in a separate entity, in effect segregating the government guaranteed activities of a bank from commercial operations.

As the events in the UK show, banks are ultimately wards of the state. It’s time regulators recognized that uncomfortable fact and devised a more effective supervisory scheme.

From the Financial Times:

The chaos of the last week over Northern Rock raises questions about the workability of the “tripartite system”, created by Gordon Brown in 1997, under which the Financial Services Authority supervises individual banks, the Bank deals with systemic crises and the Treasury provides public money. As the governor noted in his testimony before the House of Commons Treasury committee yesterday, the Northern Rock debacle also demonstrated the difficulties created by today’s company law and system of deposit insurance: the former precluded covert assistance, while the inadequacies of the latter almost ensured a run on the bank. The only point to add on Northern Rock is that the government should have added nationalisation to its decision to provide a deposit guarantee. Taxpayers should not bail out shareholders. Equity is risk capital. In banking, risks must include the drying up of liquidity….

The only reason for intervening, then, would be “strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in future.” Since then Mr King must have decided that the threat to the financial system posed by the unwillingness of banks to lend had become too dangerous. By advancing three-month money against mortgage collateral, the Bank has, as a result, abandoned two of its principles for acting as lender of last resort.

Albeit welcoming what it called “the more flexible approach” – that is, the defeat – of the Bank, the British Bankers’ Association demanded unconditional surrender, noting “concerns about the 100 basis point penalty paid by users of the standing facility”. In short, it wants the Bank to provide limitless liquidity against questionable security, without penalty. Will the Bank resist this pressure? I hope so, but doubt it.

In a game of chicken, the loser is the player who swerves first out of the way of the other driver’s car. Since the Bank is concerned about the health of the economy, while the banks are concerned only about their survival, the former is at a huge disadvantage. Apparently, the banks told the authorities they would not lend to their weaker brethren until the Bank opened its wallet. The threat was credible and the Bank swerved.

Am I unfair, then, in blaming these events on the irresponsibility of the banks? Consider that, even though the world economy has enjoyed years of good growth and the US housing market, epicentre of the crisis, has weakened but a little, credit markets are frozen. Consider, too, that the banks both created the radioactive securitised obligations and set up the special investment vehicles (off-balance-sheet banks) that they must now rescue at the expense of lending to everybody else. Consider, not least, that banks exposed themselves to the risk of illiquidity from which they expect a public rescue, at no charge.

Yet the banks are winning, not only because they are a formidable lobby, but because they can inflict such damage. Today, as a result, the government has guaranteed deposit liabilities and the Bank has taken a big step towards rescuing them from self-inflicted illiquidity. So Mr King is losing his gamble on toughness. Let us at least understand why. Our sophisticated financial system suffered a typical collapse in self-discipline. Now the authorities are under huge pressure to rescue it from its folly. Mr King’s “mistake” – what critics call his “inflexibility” – was the view that banks should no more enjoy a rescue than other businesses. Fortunately, the Bank’s provision of liquidity is not yet free. Let Mr King stick to his guns on the penalty. If not, still more dangerous crises will come.