By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
In “Lombard Street” published in 1873, Bagehot specified the purpose of a Lender of Last Resort (LOLR) as forestalling bank panics in fractional reserve banking systems. Bagehot also provided criteria that define LOLRs, which remain relatively unchanged. In fact, the Bagehot criteria have become something of a mantra: Lend freely at penalty rates against good collateral to illiquid but solvent banks. Given Bagehot’s purpose and definition, has the crisis of 2008 provided a test of the Fed as an LOLR? If so how well did the Fed perform? What are the ECB’s responsibilities as the LOLR in Europe in 2011?
To evaluate the Fed as a LOLR, one must consider how well it fulfilled the four requirements as set out by Bagehot:
1. Lend freely
2. At a penalty rate
3. Against good collateral
4. To illiquid but solvent banks
The Fed lent freely. Discount Window lending has been the vehicle by which the Fed has traditionally fulfilled its responsibilities as the LOLR. Discount Window borrowing did increase. The Discount Window loans to depository institutions peaked at close to $112,000million in late October 2008. (They were $126million in October of 2007.)
The Fed also increased other extensions of collateralized credit by to a variety of financial institutions and markets that were part of the shadow banking system. The Fed did so in order to prevent a run on the shadow banking system, the effects of which would have been similar to a run on the banking system itself. (This expansion of the list of institutions with access to the Fed as a LOLR is not unprecedented. By legal mandate, the Fed is not only the LOLR to the banking system. The Fed has also been the lender of last resort to thrifts.)
One set of vehicles was very close to the central bank’s traditional role as the Bagehot LOLR providing short-term liquidity to the banking system. The Term Auction Facility peaked near $493,000M in March of 2009. The Fed also provided short-term liquidity to primary dealers and other broker dealers through the PDCF and TSLF. Fed loans under these programs peaked near $147,700 in October of 2008.
A second set– the ABCPFF, AMLF, and MMIFF– provided liquidity directly to select borrowers and investors in money market instruments. The ABCPFF and the MMMFF (plus “deposit”-like insurance provided by the Treasury), was aimed at preventing a “banking” crisis in the MMMF component of the shadow banking system. Credit extensions via the ABCPFF and the MMMFF peaked near $145,900M in October of 2008.
However, foreign entities had also been active participants in the US shadow banking system. The Dollar denominated assets of banks not domiciled in the US is roughly the same size as the Dollar assets of the US commercial banking sector. Foreign banks, particularly European banks, activities in Dollar-denominated markets helped determine credit conditions in the US. Prior to the crisis, foreign institutions had borrowed Dollars short-term to fund positions in US assets, e.g. MBS. If foreign institutions without access to the Fed Discount Window had been unable to access market-sourced liquidity, they then would have had been forced to sell Dollar assets. As a result, the domestic efforts aimed at supplying liquidity to US-based agents to prevent the liquidation of assets would have been compromised, If not for naught. US institutions would have had to mark the prices of assets down and report lower net worth-a recipe for further pressure on US institutions. The same concerns are operative today, given the Euro crisis.
From this perspective, the Fed currency swaps with foreign central banks (who in turn lent the Dollars to institutions with Dollar liquidity problems and no access to the Fed Discount window) are consistent with its role as a LOLR. The Fed ignored geographical borders to supply the required liquidity to foreign–based participants just as it had ignored precedent and regulatory borders to supply liquidity to US institutions without access to the Discount Window. Fed currency swaps peaked in December of 2008 near $582,750M.
Like Discount Window borrowings, the lending programs required collateral. The swap lines were collateralized with foreign currency and backed by the central banks. (Given the questions that exist about the future of the Euro and hence the ECB, the “credit” risk embedded in the swap lines with the ECB are higher than they were in 2008.)
The interest rates varied across the lending programs. Some were linked to the Discount Rate which floats 100 basis points above the Fed funds rate. One was linked to the Fed Funds rate. Others were set by auction processes. The speed with which the loans made under these programs were unwound suggests that the interest rate was a penalty rate or administered in fashion that led counterparties to behave as if they were penalty rates.
These two set of vehicles closely adhered to the Bagehot requirements. The Federal Reserve ended the MMIFF in October 30, 2009. The AMLF, PDCF, and TSLF were closed on February 1, 2010.
The Fed also moved well beyond the Bagehot criteria. It created a third set of lending vehicles which were directed not at supplying liquidity to illiquid but solvent institutions, but rather at supporting asset prices and supplying liquidity and credit to sectors from which the banking and shadow banking systems had withdrawn.
The Commercial Paper Funding Facility, CPFF, was instituted to insulate the real economy from funding problems in the commercial paper component of the shadow banking system. At its peak in January of 2009, the Fed had lent close to $350,000M against commercial paper. TALF, the Term Asset-Backed Securities Loan Facility, was launched in March of 2009. It was designed to the consumer and small business asset backed securities market. TALF peaked near $48,000M in March of 2010. These CPFF and the TALF represent a clear break from the Bagehot criteria: they were not loans to illiquid but solvent financial institutions that performed banking functions. They may have been desirable, even necessary, tools for the Fed to have used to stabilize the financial system and the real economy, but they were not part of a LOLR function.
QE1, aka “credit easing”, was also directed at narrowing credit spreads and maintaining function. The Fed efforts to maintain the asset backed securities market (CPFF and TALF) have more in common with “credit easing” than the LOLR. Hence, the CPFF and TALF could be viewed as part of unconventional monetary policy and not as part of the LOLR function.
The Fed also extended credit to support specific institutions:
1. The Fed loan to Maiden Lane LLC to facilitate the purchase of Bear Stearns by JPMorgan
2. Fed Loans to Maiden Lane II and III as part of the package for AIG
The purpose of these “loans” was not to aid an illiquid but solvent institution. The Fed arranged and helped finance a merger in the case of Bear Stearns and a restructuring in the case of AIG. The Fed was performing a role that would have fallen to the FDIC had Bear Stearns and AIG been depository institutions. Furthermore, while it is the Fed’s position that the acquisition of the assets held in the Maiden Lane vehicle was de jure a “non-recourse loan”, the Fed’s acquisition of the assets was de facto indistinguishable from an outright purchase of the assets. This structure and the Fed’s position presumably reflect:
1. the perceived necessity of permanently removing the assets from the balance sheet of the entity,
2. the Federal Reserve Act which prohibits the Fed from buying the types of assets in question,
3. Congressional disapproval of a purchase of assets at a non-market price (there was no market) with the significant downside risk.
Furthermore, it has never been the purpose of an LOLR to finance corporate takeovers or the de facto nationalization of firms. Hence, the Fed was not acting as an LOLR in either the JPMorgan acquisition of Bear Stearns or the de facto nationalization of AIG, although one could argue that it was advancing financial stability. The necessity of the Fed involvement is also questionable. The Fed did not finance the government moves to stabilize Fannie and Freddie nor did it finance the government role in the bailout of GM and Chrysler.
Did the Fed fulfill its responsibility as an LOLR during the crisis of 2008? Yes. It lent freely to institutions in the banking and shadow banking systems that were experiencing liquidity problems. It lent against collateral and at rates that encouraged borrowers to unwind borrowings, which allowed for the sun setting of the facilities. Did the Fed also engage in other activities that supported market function and specific institutions? Yes, but these should not be viewed LOLR activities. Did the Fed violated the Bagehot criteria when it “lent” for purposes other liquidity and to insolvent institutions (including depository institutions) in support of the “too big to fail” doctrine? Yes.
Does the Fed as the LOLR have a duty to buy and support the prices of Treasury issued debt as some have suggested? The Fed pegged the prices (and yields) of Treasuries from the start of WWII until 1951. When after a contentious battle with The Executive branch, the Fed-Treasury Accord of 1951 ended the Fed’s pegging of the prices /yield on Treasury issues. The move has been viewed as a desirable and required step to insure a monetary policy that was free to pursuit the goals of full employment, growth, price and financial stability unencumbered by a need to maintain an unchanged yield on Treasury issuance. I do not recall anyone ever asserting that the Fed in achieving this independence had abrogated its responsibility as a LOLR. It may be desirable for the Fed to engage in another round of QE, but will be another instance of unconventional monetary policy and not an exercise as the LOLR.
Europe is in the midst of a financial crisis and the ECB is being called upon to act as an LOLR and support the prices of the debt of various peripheral countries. It may be wise, or not, for the ECB to buy the sovereign debt of the peripheral countries. It might be consider part of monetary policy or unconventional monetary policy, but given history and the definition of the LOLR it is hardly an LOLR function. An unlimited commitment to monetize the sovereign paper would imply that the ECB has surrendered any ability to control either quantity of reserves in the system or manipulate short-term interest rates. In short, its ability to execute monetary policy will have been abandoned. It would in effect become an off-budget financing arm of a non-existent and at the same time dysfunctional pan-Europe Finance Ministry.
This highlights a political dimension. While the ECB’s resistance to monetizing the debt or new issuance of debt by the peripheral countries reflects a variety of legal factors, it may also reflect the ex post criticism directed at the Fed. The Fed has been criticized by many for becoming the off-budget financing arm of the Treasury. The Executive and Legislative branches acted quickly enough to support GM and Chrysler with on budget appropriated funds. With a short bridge from the Fed, the Executive and Legislative branches moved to buttress Fannie and Freddie, again via enabling legislation. However with little popular support for a company brought down by playing with derivatives, the Fed alone financed, oversaw and took the heat stemming from the de facto nationalization of AIG. The Fed quickly became a political punching bag for decisions made at AIG, including the decision to pay all counterparties 100 cents on the Dollar. (Somehow after exceeding its mandate as a central bank and LOLR, the Fed decided it did not want to try its hand at being a bankruptcy court and allocating assets across counterparties.)
The ECB is in a position similar to that which the Fed found itself in with AIG on the brink. It is not the role of central banks or LOLRs to disguise the failures of fiscal policy, the architecture of the EZ or the political system any more than it is to bailout insolvent companies. The Fed is paying a political price: the Fed and monetary policy have become political footballs. It could have been avoided if the Fed simply said we will do with AIG what was done with Fannie and Freddie, i.e. the Fed provide limited support support in the very short-term with an agreed upon understanding that Congress and the President will provide the long-term solution and financing as well as an exit for the Fed.
The ECB can avoid both a near-term Euro crisis and the problem faced by the Fed, if it announces that it will buy the sovereign debt of the peripheral countries only if it can achieve a public agreement with the governments that stipulates the conditions under which it will buy the debt, a predetermined schedule, and ceiling the purchases and an predetermined date for an exit. The agreement will make clear that the ECB will provide help for a limited period of time in which the political process will have time to forge a permanent solution to the crisis. It will also put the focus back on elected official as well as give them a time limit and a reason to agree upon a solution to the underlying structural problems.
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This article, like others on the site, seems naive on the ECB.
Of course the ECB can (and will eventually) stabilize the Eurozone by guaranteeing sovereign debts. But in pointing out that this is what the ECB can, should, and must do, somehow, many commentators seem to miss what seems obvious (to this reader, at least). Namely, the ECB is in an incredibly powerful position: if, when, and how it acts determines the EZ’s future, and with it, that of the U.S. and the rest of the world to a large extent. The ECB is not a neutral actor: it has its own interests which are closely aligned with finance capital, and particularly, Goldman Sachs (look at Mario Draghi!). The ECB wants to control the Eurozone, to dictate economic policy of the EZ nations, which will of course entail severe austerity and make every attempt to dismantle welfare states and privatize public resources.
The ECB will ‘stabilize’ the EZ as soon as it can dictate the terms of a settlement–which will probably be pretty soon.
Trickle Down Bail Out cannot work to start the global economy even if you bail out all the business and the COUNSUMER can’t spend any money the businesses will at best just pay power electric rent etc. and go in to the red again. Their has to be some type of government sponsored infrastructure rebuilding or a bail out to all citizens like Mr. Keen spoke of to put money in the little guys pocket. Then and only then will the economy start to rebound.
The powers that be don’t want to see that happen they just want to bathe them selves in False Profits with trickle down till they die,easy money and they don’t have to work for it. Kick The Can Man generate banking fees thats the name of their game.
Yes, well unfortunately, the institution you want to keep in political power to fund a “trickle up bailout” is not the German Non-Luxury Automobile Maker’s Chamber of Commerce.
Wait–is there even such thing as a German non-luxury auto maker? Maybe you should try the Chinese. Wait–the Chinese already said “No,” didn’t they?
“Europe is in the midst of a financial crisis and the ECB is being called upon to act as an LOLR and support the prices of the debt of various peripheral countries. It may be wise, or not, for the ECB to buy the sovereign debt of the peripheral countries. It might be consider part of monetary policy or unconventional monetary policy, but given history and the definition of the LOLR it is hardly an LOLR function.”
Absolutely right. Bill Mitchell pointed this out last week. I was just happy that people had started finally talking about debt monetisation — which absolutely has to occur — and so let it slide. I think the FT crowd were key in tacking on this misnomer. But it made the whole thing sound a lot ‘safer’ to the mainstream in that it made it sound like something that was already in place in other countries — which is stretching the truth, to say the least.
But I believe this misnomer has played a real historical role in getting the ECB actions accepted. And these actions may play an historical role in our understanding of what central banks can really do without provoking inflation. We’ll be better for it.
That the institutions had to become political footballs is unfortunate. And I’ve seen the pseudo-Austrians and the conspiracy theorists make more than one convert by plugging this line. But they did it. And history will smile on them.
I know, it’s fashionable to get all PHD economic about the situation, but isn’t this really about how the politicians and financial terrorists plan to make the taxpayer take the hit for institutional malfeasance?
It’s all about how they can avoid having the people responsible for this calamity be held to account.
I am still dumbstruck at how the EU can dismiss democratically elected governments and replace heads of state with Goldman Sacks alums. It’s mind boggling that there is not an uproar so loud as to shake the very foundations of civilized society about this blatant criminality.
No, let’s talk about lenders of last resort.
No, in this case it’s precisely the opposite. The central bank is stepping in to assure the markets of the ‘taxpayer’s’ ability to borrow money and fund his state.
ECB steps in ONLY on condition of austerity writ large amongst member nations. That’s a self defeating, non bargain for the PEOPLE in said member nations.
True. But we’re not really bailing out the bankers on this one. It’s a whole different ball game. And I fear its misunderstood by many in America whose bailouts really did go to idiots bankers.
“But we’re not really bailing out the bankers on this one. It’s a whole different ball game. And I fear its misunderstood by many in America whose bailouts really did go to idiots bankers.”
So the ECB is a bridge to each sovereign states bailout of the “idiot bankers”? Looks like no matter how it is done, the “idiot bankers” still get their welfare payment from the sovereign state.
Excuse my ignorance, but aren’t these measures designed to prevent bonds from defaulting or triggering CDS credit events. And are the banks not the beneficiaries of these efforts to pass off the losses on their bad bets to the citizenry via austerity?
That is why, that as long as these criminals and their Media cohorts, control the narrative, and obfuscate and out right lie, we can never get to the crux of the matter.
The system needs a restart, a do over. And as at least one condition, nobody, and I mean nobody, currently involved in the current Financial oligarchy will be allowed to take part.
Not bailing out the banks?! Not bailing out the banks?!
If you honestly don’t think that all of the machinations of the troika over the last year are anything but attempts on the parts of bankers to find ways in which they are able to save themselves and their institutions at the expense of sovereign nations and the people within them, I really don’t know whether to believe you are tragically misguided or insidiously obtuse.
“Excuse my ignorance, but aren’t these measures designed to prevent bonds from defaulting or triggering CDS credit events. And are the banks not the beneficiaries of these efforts to pass off the losses on their bad bets to the citizenry via austerity?”
Eh. No.
A lot of Americans don’t get this one at all.
It ain’t the banksters this time around, guys…
Well, it’s definitely a backhanded bailout of the banks, but it’s also to prevent a run on sovereign debt and collapse of the global financial system…
As far as the article goes, I don’t think that it’s correct to frame the Fed’s actions only in the LOLR context. The Fed has a mandate, which shouldn’t be contained to LOLR. On the other hand, it’s hard to say that the Fed doesn’t blatantly favor the financial institutions. Why not give Americans a debt jubilee if it was really interested in reducing unemployment? Why not completely monetize the US debt? Offer negative interest rate loans? I think that evaluating the Fed’s actions in response to this crisis need to be part of this broader conversation.
Not about bailing banks? Horseshit. Oh, we may see the gutted husks of a few banks go down, but it’s those who did the gutting whose loot is being not just protected, but handsomely augmented. Who do you suppose convinced appallingly naive European and US government technocrats, then politicians, that all of this hyper-leveraged economic activity was safe in the first place? That the implied backing of governments meant you could go stark raving mad? That individuals or regions, or whole countries could suddenly be “wealthy” though nothing had changed with regard to their respective outputs? It wasn’t taxi drivers. It was the smartest guys in the room. The ones who, far from getting weaker, are exercising their power right out in the open. You think the beating now being laid on Europe could’ve taken place pre-2008? Not a frigging chance. Having so completely intimidated virtually everyone save a few REAL seekers of change (eg., Chris Hedges) they now act with the full blessing of folks like yourself, who seem incapable of conceiving anything other than a bi-polar choice of total capitulation vs Armageddon.
The reality is that the false imperative that keeping THIS financial system train on the track trumps all other considerations will prove to be far, far worse than any Depression.
Thank you, Fiver.
The banks are supposed to do “due diligence” to protect their investments and since they are “sophisticated” investors, there is no need for bailout if the banks made the choice of potentially risky investments.
“The ECB can avoid both a near-term Euro crisis and the problem faced by the Fed, if it announces that it will buy the sovereign debt of the peripheral countries only if it can achieve a public agreement with the governments that stipulates the conditions under which it will buy the debt, a predetermined schedule, and ceiling the purchases and an predetermined date for an exit.”
How much more anti-democratic can you get? The ECB, essentially a sockpuppet of German plutocrats, dictates terms of surrender to the 99%s of Europe, and then leaves. Problem solved!
We have been saying for an age that Europe has multiple problems, financial, political, and in its trade that must be resolved to reverse its descent into kleptocratic neofeudalism. None of this is addressed. Instead we get a long irrelevant exposition on whether what the ECB needs to do would fall under the rubrique of lender of last resort.
The ECB needs to be the buyer of last resort and its commitment to buy needs to be open ended and unlimited. We have already seen how quickly speculators have dismissed these kinds of more limited, clearly delineated ECB interventions. Indeed Alford’s prescription looks a lot like ECB and European policy to date. But this policy approach has failed for the reasons we already know. 1) The ECB is not an independent player but a creature and expression of the German elites. 2) None of the underlying problems which produced this crisis: insolvent banks, kleptocratic elites, corrupt politicians, mercantilist trade, the lack of fiscal and debt union, and an ineffective ECB are resolved. 3) The ECB’s “austerity” solution will simply exacerbate the crisis.
A solution to Europe’s problems must be holistic in nature and depends upon the overthrow of its kleptocracy. As here, elites are so entrenched and permeate public institutions that anything short of revolution will fail to dislodge them. This is the heart of the matter. Alford’s approach, as well as that of so many others, continues to accord various players the presumption that they are acting or will act in good faith. But this isn’t the case. The European crisis has been going on for close to two years now. If there was going to be any good faith attempt to resolve it, we would have seen at least some evidence of it by now. But we have seen nothing. And it is not just that we have not seen the necessary elements of a solution coming together. Most of the underlying problems have been totally ignored. Consider that. European elites with all their experience, power, and resources and some how they have just happened to fail, and continue to fail, to see what we have been discussing here for more than a year.
Where does that leave us? That European elites are so incompetent they should lose their positions, wealth, and power or that they are acting in bad faith. We have had this conservation many times too. If it were incompetence, we might expect the elites to make decisions on occasion injurious to themselves and which benefited ordinary citizens. But we do not see this. Instead we have the institutionalization of the privatization of gains and the socialization of losses. That argues strongly for bad faith. Europe’s elites don’t want real solutions because real solutions would be the end of them. What is hard to understand about this?
The blog post gives a pretty good overview on what central banks are supposed to do and what rather not.
The problem of the Eurozone is the existence of massive imbalances between periphery and core. To make the Eurozone viable without massive fiscal transfer these imbalances have to be reduced. Periphery needs to deflate and core needs to inflate. This is very tough to manage within one currency. Maybe loser monetary policy by the ECB could help with that more than it does now. Monetizing sovereign debt is not monetary policy though and it it is in no way obvious how it could help reducing the imbalances.
If the imbalances persist the EZ should fall apart sooner or later anyway.
There an enormous effort going on to bully the ECB into debt monetization.
Who will really benfit from such a policy move? Looking at the people who are promoting this option now, I start to feel even more uncomfortable with it. See this guy obviously in fear :
http://www.bloomberg.com/video/81861054
Luckily the bad guys are not the bankers any more, but now its the Germans and of course the ECB which is serving the interest of Goldman Sachs… No wait stop, now I am getting confused. Which firm was this guy actually working for?
Goldman, JPM, et al along with Blackrock, hedgies, other private equity, PIMCO, everyone is licking their chops at the prospect of a massive ECB intervention, which is why GS has their normally Mr. Optimism (O’Neill) out pounding the drums for infinite backstopping.
A forced fiscal union is a recipe for endless conflict and accelerating decay. We will see pledges, and plans for it, but in the end I don’t think we’ll see it except perhaps for the core. Only Empires have ever had such a makeup. That it is being urged by the elite consensus barking edicts from the Anglosphere is more than a little instructive. It is appalling.
Ah interesting, this posting happens just after a discussion on the Bagehot rules at another blog which started on Dec. 1st:
http://andolfatto.blogspot.com/2011/12/on-bagehots-penalty-rate.html
The blogger there was discussing whether a penalty rate is really necessary, but also under a rather truncated set of Bagehot rules.
I did not manage to post a couple of my usual memos on the distinction there between “lender of last resort” and “donor of first resort” roles, so I hope that it will be useful to post them here instead.
Now a serious complication comes from the case where the two scenarios overlap: there is a run on a bank (liquidity panic) because it has lent to a business (or sovereign) that has insufficient cash flow and collateral to service their loans if not now in the the future (business insolvency).
In that case everything hangs on whether the collateral posted by the bank for discount at the lender of last resort is deemed good or not, because in that case that collateral must be the impaired debt of the business or sovereign (because if there is enough other collateral the run on that bank would not happen).
I would reckon that Bagehot would consider that bad collateral, because his rule is about safe collateral, and the business/sovereign collateral at the root of the bank run is obviously being questioned by the markets.
So it is really a case where the lender of last resort has the opportunity to fudge it: to appear like a lender of last resort by extending loans to banks suffering from a bank run, but being really a donor of first resort by accepting collateral that is deemed unsafe by the market.
There may also be the circular problem that the unsafe collateral is deemed such only because the rate is too high because it is deemed unsafe, so the lender of last resort accepting it and lending at a low rate breaks it.
But what is a safe lending rate on a marginally solvent business/sovereign borrower which may or may not spiral out or into insolvency is again an investment decision and should be supported by equity not temporary loans.
In the business case the situation is usually clear: businesses that have cash flow problems get put into administration (chapter 11 in the USA), and they may get lender-in-possession loans or new equity or else put into liquidation (chapter 7 in the USA), and banks that lent too much to them are also put into administration waiting for the borrower mess to be resolved. That does not apply to the world of TBTF banks and their sovereign borrowers.
In past cases lenders of last resort have only been happy to fudge it massively for their TBTF friends-of-friends (in the USA massive loans apparently were secretly extended to banks without collateral and without interest to get them over “liquidity” issues, and before that the Bank of England famously lent against whatever in panics at least some time in past centuries).
But that seems quite outside Bagehot guidelines, which are really about safe collateral and bank run panics. Perhaps new guidelines are needed (and Buiter etc. proposed some new ones).
Or perhaps governments everywhere should stop using the fig leaf of central banks and lenders of last resort to solve what are in essence credit and not liquidity risk issues, voters should be be less hypocritical and gullible and reward them for doing so, and the central bank should lend a pony at a zero interest rate without collateral to every little girl (think of the fantastic PR! :->).
December 3, 2011 3:36 AM
On some corner cases…
My summary: in the Bagehot case, which is about banks (lenders), and good collateral (lender capital in effect), the penalty rate is to make sure the emergency discount window is used as little as possible, as he wrote explicitly, and the good collateral is to ensure that liquidity is not extended to the insolvent banks, only the illiquid ones.
The assumption is that the penalty rate is a fine paid by the shareholders of the bank either out of current profits or out of capital, and the total cost is small anyhow because the liquidity loans are of short duration (because the penalty rate is high).
But it can happen that a lender is solvent but not by much, and paying a penalty rate during a panic would make it insolvent, at least marginally. In the case of banks one can argue that however marginally insolvent banks are the norm, and anyhow the test of solvency in Bagehot’s case is the good collateral, not whether it can afford to pay the penalty rate, and anyhow marginal insolvency can be fudged (which is the reason why banks try hard to be at least marginally insolvent, as it is more profitable).
There is a similar case today: Italy. Their debt is solvent if the rate is low, and insolvent if the rate is high.
But note that Bagehot’s rule cannot apply to sovereigns because they are not banks, and most importantly there can be not collateral.
Also sovereigns are not banks, they are borrowers, not lenders.
The true rationale and applicability of Bagehot’s rule is to banks because almost by definition a bank explicitly borrows short term and lends long term against collateral, so it can be subject to a liquidity problem simply because the short term borrowing can become insufficient even if the long term loans are good and backed by good collateral.
The problem here is purely the term structure, if one assumes that eventually the short term borrowing will resume, and assess correctly that the collateral is good.
A bank *customer*, that is a borrower, instead has a completely different financial structure. For example a manufacturer can go through something that looks like a temporary liquidity crisis, if for example it has funded production via loans and it suffers a fall in sales that do not allow it to generate enough cash flow to service the debt. The Italian case is similar to this.
The thing with the fall-in-sales business scenario is that it is not a liquidity problem: it is an insolvency problem. Because whether the fall in sales is temporary or permanent is not a liquidity issue, it is a business issue. It requires making an investment decision, that is supplying equity to the business, subject to business risk, not liquidity risk, because the fall in sales might indeed be a fundamental problem with the business. Put another way if the business cannot survive a period of slow sales it is undercapitalized, not illiquid.
Another vital difference between the business and the bank case is that the usually the business in the case above does not have collateral to support a “liquidity” loan because it has already used it to support the “business” loan it cannot service. It is a difference because banks do not usually offer collateral to their depositors and other sources of short term funds, but require them from their borrowers.
Put it yet another way Bagehot’s rules were intended for the case of a bank run, not for the case of insufficient sales.
In the sovereign case the issue profile seems much nearer to that of insufficient sales than to that of a bank run.
Therefore the lending decision should not be based on the Bagehot rules, but the usual principle used by banks or venture capitalists deciding whether to throw some money into a risky situation: future cash flow, not quality of collateral.
December 3, 2011 3:27 AM
A technical note here:
«1. Lend freely
2. At a penalty rate
3. Against good collateral
4. To illiquid but solvent banks»
Strictly speaking the Bagehot rules are only the first three.
The «To illiquid but solvent banks» is not a rule, it is a boundary condition, a rationale for the rule «Against good collateral».
As to that there is a second boundary condition, «during a liquidity panic», the rationale for the rule «At a penalty rate», because the lender of last resort should not «lend freely» in normal times or to banks that don’t have a liquidity problem.
There is an overarching rule or condition that I have mentioned in my two previous memos: that the central bank is supposed to provide liquidity loans only to banks or other financial intermediaries.
The reason why that is a very important is that the purpose of providing liquidity during panics is to couneract the term structure of banks and financial intermediaries that borrow short term and lend long term.
Put another way the Bagehot rules are not really about the central bank being the lender of last resort, or even the counterparty of last resort, but the depositor of last resort.
Because from the Bagehot point of view a liquidity panic is synonymous with a bank run, that is a mass pullout of short term deposits from financial intermediaries that have long term assets and short term liabilities.
The distinction is very important in practice. Because the word lender evokes also ideas of supporting investment; for example a bank that provides business or house improvement loans is in effect in part investing.
The Bagehot rules address instead narrowly the case where the central bank replaces fleeing depositors, in the case where the depositors flee the bank (or other financial intermediary with a risky term structure) because of uncertainty about its solvency due to asymmetric information, where the central bank instead by examining the collateral can be a depositor of last resort knowing that the bank is solvent.
None of this applies to businesses, sovereigns and other entities that do not have a risky term structure and are not financial intermediaries.
«While the ECB’s resistance to monetizing the debt or new issuance of debt by the peripheral countries reflects a variety of legal factors, it may also reflect the ex post criticism directed at the Fed.»
Oh no. Rules matter but not that much, and the Fed example is not that relevant to the ECB.
The problem is purely political: the ECB cannot make a revolution and do something that goes against the very obvious wills of some of its major sponsors. If the ECB monetizes debt for some countries ignoring the voters of the other countries, including German, Dutch, Finnish voters, the voters of the other countries will at best ignore the ECB (and then it ceases to exist), at worst feel betrayed (and then something bigger than the ECB ceases to exist).
«The Fed has been criticized by many for becoming the off-budget financing arm of the Treasury. The Executive and Legislative branches acted quickly enough to support GM and Chrysler with on budget appropriated funds. With a short bridge from the Fed, the Executive and Legislative branches moved to buttress Fannie and Freddie, again via enabling legislation. However with little popular support for a company brought down by playing with derivatives,»
It is not «popular support»: it is the support of a House run by people who want to damage the re-election prospects of the President. As you well know, the House leadership sent a public menacing letter to the Fed about using monetary means to rescue the economy and thus boosting the President’s popularity.
The Fed has the inestimable advantage that it uses «unappropriated funds» and therefore as long as it pleases them to do so, they can implement policy without a House vote.
«(Somehow after exceeding its mandate as a central bank and LOLR, the Fed decided it did not want to try its hand at being a bankruptcy court and allocating assets across counterparties.)»
That seems an amazingly optimizing misinterpretation.
The Fed did not want AIG creditors, which are ultimately largely pension funds and savings funds, to take a very large hit. Actually even worse: by far the biggest creditors of AIG are individual policyholders, in particular life policies used as savings vehicles because of the tax advantages.
The Fed and the Administration did not want to have several dozen million people’s savings and pensions vaporized, and to cover that risk they decided it was most expedient to just recapitalize AIG fully, to make sure very few people understood what was at stake, and that meant paying off everybody.
The AIG case, even more so than the GSEs and the banks, is the really big horror of the recent crisis: insurance companies are supposed to be really safe. Their whole business model depends on that, because their customers don’t want to pay premiums for decades to see the insurer vanish at some point.
But the insurance business model plus the “vanish” final act is exactly what most financial institutions are trying to aim for, because it is immensely profitable to insiders.
Summary: the Fed Board has been effectively acting as insurer of last resort, which is one of the major fiscal roles of governments, because Treasury cannot get the necessary appropriations through has a House that is aiming for failure, because most voters blame Presidents and not the House for fiscal policy.