The ECB as the Lender of Last Resort

GEI welcomes Dirk Ehnts as a regular contributor.  His bio can be found at the end of this article.

The European Central Bank has acted as a lender of last resort (LOLR) during the crisis. It has lend freely and without limit. Many commentators have applauded this policy, and today you do not find much discussion on it. However, in these times there are no no-brainers. Let me bring up the excellent Willem Buiter:

The Bagehotian LOLR intervenes for two reasons.

(i) Bank runs are unnecessary. Typically, the formal models of bank runs show that there exist (at least) two equilibria: one in which there is no bank run and at one in which there is no bank run. Without a central bank acting as LOLR (or some other device like compulsory bank holidays, in which the sequential service constraint (the first-come, first-served right of depositors to withdraw their money) is suspended), there can be a ‘coordination failure’ causing depositors to focus on the wrong equilibrium, the ‘run’. The LOLR eliminates the run equilibrium.

(ii) Bank runs are costly. They may cause banks to go bankrupt; they may impair the payment system (whencheckable bank deposits are an important means of payment) and they may interfere with the ability of the banking system to extend new loans or roll over existing ones, thus impairing the supply of trade credit, working capital etc. etc. Bankruptcy is socially costly. It is not just a reshuffling of ownership claims. Real resources are wasted on lawyers, auditors, accountants and bailiffs. ‘Going concern value’, including goodwill may be destroyed. Established relationships between borrowers and loan officers may be interrupted and social capital diminished.

Let me add one more thing: a central bank should only go into LOLR mode if there is a liquidity crisis. A liquidity crisis is a situation where financial institutions are fundamentally sound, but find it difficult to roll over existing debt because of adverse conditions in the financial markets.

A completely different situation is that of an insolvency crisis. Here, financial institutions are bankrupt because of lending to borrowers who cannot repay, or buying assets that turn out to be non-performing to a large extent. The policy conclusions of these two cases, as you might already understand, are not the same: whereas in a liquidity crisis LOLR is the right policy, it is not in an insolvency crisis. Bankrupt financial institutions should be allowed to fail in order to distribute the losses to those responsible.

Sadly, the European institutions have agreed to rule the financial crisis a liquidity/public debt crisis. It is, however, clearly an insolvency/private debt crisis. European banks have invested in toxic assets (mostly mortgage-related) and, when faced with the consequences, went into bankruptcy territory. They were then bailed out by the public. Now the public – via the ECB – holds some of the toxic assets, which seem to generate heavy losses. This is the story behind the ECB capital boost from this week. (By the way: 2,5 years ago Willem Buiter was ridiculed for asking “Can central banks go bust?“. It seems now that Europe might turn into another Iceland, both in weather and finance.)

In conclusion, the diagnosis of the crisis is wrong and the policy prescription on this basis will be wrong as well. As in other parts of life, two wrongs don’t make it right. Expect euro wobbles to be with us in 2011 and beyond.

3 replies on “The ECB as the Lender of Last Resort”

  1. While I agree with the analysis, the question is also how much social and financial dislocation and contagion from bank failure and how fast.

    Look at the riots in Greece, UK, Italy and France and now imagine the result of no interference in the market economy as it was in 200/7/8/9.

    My guestimate would be lots of civil unrest, rioting and bloodshed leading to even worse social and financial conditions for the majority of the population, but of course your guess might be different.

    Amelioration has its benefits both by quantum of loss and by time taken to work to final loss. This will result in losses not necessarily falling where they might originally have fallen and there will no doubt be successful rent seeking behaviour favouring powerful elites in the main, but the overall balance is a subjective and political decision.

    What seems most clear is that virtually every government has chosen amelioration in 2008/9/10 as did Japan after 1990. This result is no doubt tinged/driven by a desire to remain in power as well as by a view that it is the “best” course of action.

  2. Yes there would be dislocations and economic chaos if systemic insolvency of banking systems in Europe and America were acknowledged and those failed banks taken into receivership for systematic liquidation. But who, pray tell, would possess the cash to buy the liquidated assets in a systemic insolvency resolution? All assets would clear at firesale prices and the few people possessing money would buy up our economies for a song. This is not a practical solution.

    So the issue becomes, who gets the bailout money? So far the answer has been, Wall St gets the trillions. This is fundamentally unfair to the rest of the economy as well as being moral hazard writ large. Bankers are once again paying themselves record bonuses for their stellar performance, at acquiring bailout funds and regulatory forbearance. These are megabillion welfare cases, not ‘successful’ private enterprise banks.

    The problem is that all the bailout Money has gone to the supply side of the monetary equation, the banks who made loans that are now non-performing. A more equitable solution to bad loan systemic insolvency would be to take the same trillions that are being given to the banks, and give the money directly to all American households as $1000 per month “solvency checks”, with a provision that anyone with bank loans must devote all of their check to paying down their debts. This would restore practically all loans to performing status. All Americans get the checks, so we’re not rewarding failures at the expense of the financially prudent.

    Debt repayment extinguishes the money along with the debt so there is no addition to the money supply when solvency checks are devoted to debt paydown. There is only debt reduction. As loans are written down on bank balance sheets, the amount outstanding approaches the current market value of the real estate or other assets held by the banks as collateral against the loans. Once loans outstanding = market value of banks’ collateral assets the banks are no longer insolvent.

    This program bails out the banks by bailing out the demand side of the monetary equation, the debtors. Americans with little or no debt could devote their checks to savings or investments or to increased consumption. Investment and consumption create demand in the domestic economy which is stimulative.

    The Fed can provide nearly free money to fund the solvency checks by buying 0 – 0.5% interest Treasury bonds through the primary dealer network, in the same way it is currently buying old Treasury debt from the banks, and the banks use the Fed’s money to buy new Treasury debt.

    At present there are way too many US dollars concentrated in ‘dark pools’ and used for domestic and global speculative ‘investments’. Speculation is entirely unproductive, a zero sum casino of financial assets where one player’s gains can only come as some other player’s losses. Normally the same money that was created as a loan and spent into the economy by a borrower will eventually be earned back out of the economy and returned to the bank to pay off the loan. Creation of the loan added to the money supply, repayment of the loan extinguishes both the debt and the money which reduces the money supply. That is how money supply works in a balance sheet banking system like ours.

    But if loans are repaid with new money created by the Fed to buy Treasury’s solvency bonds, the old money that was created when the original loan was made is still out in the economy where it can contribute to CPI inflation (if it in the hands of spenders) or asset hyperinflation if the money is in the hands of dark pool speculators. These pools should be reduced via taxation, maybe a scaled up version of a Tobin tax or a more targeted tax. Tax revenues taken in this way could be used by Treasury to redeem it’s solvency bonds from the Fed, which would extinguish the tax money by taking it out of the economy and using it to repay debt as should have been done in the first place if all that money had been reinvested in America’s productive economy where it could have been earned as incomes by debtors who could then have repaid their bank debts from income rather from their solvency checks. As is, the money ended up in the financial casino economy where it is not accessible to most Americans who owe bank debt.

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