April 10, 2013


How to Save American Finance from Itself (ROBERT M. SOLOW, 4/08/13, New Republic)

Central banking is not rocket science, but neither is it a trivial pursuit. Excellent books have continued to be written about the art and craft of central banking, from Walter Bagehot's Lombard Street in 1873 to Alan Blinder's Central Banking in Theory and Practice in 1998. Running a central bank is in one way a little bit like flying a plane or sailing a boat: much of the time standard responses and small adjustments will do just fine, but every so often a situation arises in which fundamental understanding, knowledge of history, and good judgment can make the difference between riding out the storm and crashing. There was no such person in charge in 1929, and the result was disaster. There was one in 2008. [...]

A more general description of what banks do is "maturity transformation." They incur short-term debt (deposits) and acquire longer-term, and therefore riskier, assets (such as loans to start-up businesses). This is a socially useful function: it enables savers who want instant access to their money to finance businesses that need to lock up capital for a long enough time to focus on the design, the production, and the marketing of a product. Human greed and ingenuity being what they are, a vast variety of financial institutions has been created to engage in maturity transformation and, analogously, risk transformation. They are not "banks," so they are not regulated and overseen as banks have been, and they are not required to provide as much public information; but neither do they come under the protection of the FDIC or the lender-of-last-resort function of the Federal Reserve. And since they can be much more complex and opaque than banks, it may be hard even for relative insiders to know what may go wrong, or when, or exactly where.

This complexity and opaqueness matters more than you might think, and not just because they enable the well-informed to fleece the less well-informed. Two aspects are important. First, most of these non-bank financial institutions were very highly leveraged: their assets had been acquired almost entirely with borrowed money, and there was only a thin layer of owners' capital supporting this leaning tower of sometimes risky assets.3 This meant that even a small gain on the large volume of assets would translate into a huge rate of profit on the small amount of equity capital invested; but it also meant that a small loss on those assets (or even a profit smaller than the interest cost of all that borrowed capital) would eat up the owners' equity and leave the creditors facing possible default. Second, financial institutions had all borrowed and loaned to each other in ways that were not public.

So if A looked shaky, then B, C, and D, who might or might not have lent heavily to A, would perhaps not be repaid, in which case E, F, and G, who might be creditors of B, C, and D, were also possibly in trouble. The natural tendency in scary situations is to pull in whatever debts can be pulled in, and hunker down. The tendency of illiquidity to transform itself into insolvency is again at work. That all this happens in a fog of uncertainty only makes it worse. It is like a little old bank run, only on an enormous scale. A densely interconnected, highly leveraged financial system is intrinsically vulnerable to a collapse of this kind. And if it does implode, it is likely to drag the "real" economy with it as financing dries up for wage and salary payments, inventories, and materials.

What actually happened in 2008 and its aftermath was bad enough, and it is still going on, but it could have been worse had the Fed and the Treasury not stepped in as lender of last resort not just to banks but also to the whole financial system, and even beyond the financial system. The case of AIG is an example of a complex financial institution so strongly and opaquely interconnected with others that it had to be rescued, however distasteful that might be, for fear of the collateral damage that would be done by its failure. This is not to deny that AIG's creditors, who were not exactly babes in the wood, might have been allowed to take some losses, just as a learning experience.

Perhaps the biggest tactical mistake of the rescue operation was the decision by the Fed and Treasury to let Lehman Brothers go bankrupt: not because the owners and creditors of Lehman deserved better, but because the collapse of Lehman seemed to intensify the panic dramatically. Bernanke says that he had no choice, because Lehman was insolvent. I am not convinced. Bernanke is very good on the significance of this experience, though necessarily brief. The lesson he teaches is that the Fed can no longer focus so near-exclusively on monetary policy. It, and the other regulatory agencies, have to pay more effective attention to that third mandate, the preservation of financial stability.
Posted by at April 10, 2013 6:40 PM
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