The problem is what economists call the stigma of borrowing from the central bank. Imagine a financial institution that is facing a run but has good assets usable as collateral for a central bank loan. If all goes well, it will borrow, replacing the funding lost to the run; when the panic subsides, it can repay. However, if the financial institution believes that its borrowing from the central bank will become publicly known, it will be concerned about the inferences that its private-sector counterparties will draw. It may worry, for example, that its providers of funding will conclude that the firm is in danger of failing, and, consequently, that they will pull their funding even more quickly. Then borrowing from the central bank will be self-defeating, and firms facing runs will do all they can to avoid it. This is the stigma problem, and it affects everyone, not just the potential borrower. If financial institutions and other market participants are unwilling to borrow from the central bank, then the central bank will be unable to put into the system the liquidity necessary to stop the panic. Instead of borrowing, financial firms will hoard cash, cut back credit, refuse to make markets, and dump assets for what they can get, forcing down asset prices and putting financial pressure on other firms. The whole economy will feel the effects, not just the financial sector.
Pointer from Mark Thoma.
In effect, Bernanke is saying that you have to make firms that get into trouble want to be bailed out. If you make bailouts too painful for them, then “financial firms will hoard cash, cut back credit, refuse to make markets, and dump assets.”
I am not impressed by his reasoning. What he calls “stigma” is not a bug of the Bagehot principle. It is a feature.
De we really have a good theory of “Unnecessary and irrational asset sell-off and price collapse in a panic?”
That’s seems to be Bernanke’s implicit model here, but it doesn’t make much sense. You don’t have to bring in the EMH to wonder whether is can really be true that we all ‘know’ that prices are temporarily trading below what the assets are ‘really worth’, but that there simply aren’t enough non-panicking sober and patient contrarian investors “buying when there is blood in the streets”, or that they are simply too liquidity constrained to take advantage of the obviously profitable buying opportunity.
I recall all the demonization of ‘mark to market’ rules during the run-up to TARP, and the insistence that the problem was illiquidity (or at least, exposure to a risk of collateral calls without any contingency plan) and not really insolvency (i.e. real losses deriving from bad bets related to the mortgage markets and housing bubble).
But in the aftermath, now that the dust has settled, the verdict seems to be that the market wasn’t all that crazy or irrational after all in recalculating what some of the subprime bets were really worth, and that insolvency really was a big problem.
Mr. Bernanke is still in the conceptual grip of the barbarous relic. He thinks that money is something you can run out of. He of all people should know better.
When tangible money was abolished, a vestigial accounting system remained.
This accounting system was in its origins and at its core, an inventory monitoring tool for hard money. There is no longer an inventory to monitor. Accounting is now a only a set of rules for changing ledger entries. The set-point of zero dollars as the solvent/insolvent demarcation is utterly arbitrary. It can be moved.
Any banking crisis that is seen as solvency problem can be resolved by moving the set-point. Call it GAAP 2.0, call it overdraft protection, call it regulatory forbearance, call it dynamic TBTFness, or whatever; Excel handles negative numbers just as well as positive ones. The word “borrowing” need never be uttered. No word, no stigma. The whole shell game of 2008 could have been avoided if the Fed had taken this straightforward approach.
The only banking panic to be feared is the one that goes by the name revolution.
In banking, the line between insolvency and illiquidity is thin. Bernanke seems to be in “assume a crisis.” But the banks who need to borrow and are afraid to make it known they are in trouble probably are in trouble, thus the crisis. During the past crisis, there was a round where a lot of banks were encouraged to borrow from The Fed. They could do that. Or banks could borrow from other banks at mutually agreeable rates. The mark-to-market could be smoothed over a reasonable period. The main point is that government capital requirements of all forms shouldn’t be what forces bankruptcy and pro-cyclical crisis.