Mmuch about The Silicon Valley bank crash was very recent. Bank name. A client base of venture capitalists interested in technology. The panic caused by the tweets. Cash withdrawal via smart phone. At its core, though, was the Lender’s downfall, the latest iteration of the bank’s classic trading. The solution, a central bank intervention to shore up the financial system, was also time-honorable. The topic in economics is so well circulated that the lyrical phrase describing the actions of a central bank, “lender of last resort,” is often reduced to its hard abbreviation, Lawler.
A review of history shows both typical and unique in the case of Silicon Valley Banking. There is ample, if imperfect, precedent for the Fed’s actions. However, they continue the alarming trend of broader interventions, thus distorting the financial system. This raises questions about whether, in the long run, the Fed’s pursuit of stability is hurting the economy.
It will be restricted for the V column The Economist To overlook the person who is often credited with formulating a theory Lawler: Walter Bagehot, editor of this newspaper in the nineteenth century. Over the years, his ideas developed into a rule for how central banks should deal with panic: lend quickly and freely, at a punitive rate, against good collateral. As Sir Paul Tucker, formerly of the Bank of England, said, the logic is twofold. Knowing that the central bank is behind the commercial lenders, depositors have less incentive to flee. If a run occurs, the intervention helps limit sell-offs.
The oldest writings of Bajhot is the clear objection to this Lawler: This is a moral hazard. Foreknowledge of central bank involvement may lead to bad behaviour. Banks will hold on to fewer liquid and lower-yielding assets, piling instead on riskier lines of business. How to prevent panic without sowing new risks is perhaps the central question facing financial regulators.
The clearest evidence of the need for financial support of some kind comes from earlierLawler years. There were eight American bank panics in the half century between 1863 and 1913, each of which dealt severe blows to the economy. The government responded by creating the Federal Reserve System in 1913. But breaking into regional fiefdoms, it was very timid in response to the Great Depression. Only in the aftermath of that crisis did America prove its reality Lawler Domain. Power was concentrated in the Federal Reserve Center, while the federal government provided deposit insurance. To reduce moral hazard, other tools such as caps on deposit rates have restricted banks. left this year Lawler Since then: the authorities provide support and impose restrictions. Striking the right balance is very difficult.
In the decades after the Great Depression, the Fed seemed to put an end to the bank runs. But starting in the 1970s, when inflation rose and growth fell, the financial system came under pressure. On each occasion the officials expanded the playbook. In the 1970’s the problems that arose outside the banking system were eliminated. In 1974 they auctioned off a failing bank. In 1984 they guaranteed uninsured deposits. In 1987 they injected liquidity into the banking system after the stock market crash. In 1998 they helped break up a hedge fund. Even if each episode was different, the basic principles were consistent. The Fed was willing to let some of the dominoes fall. Eventually, though, it will stop the chain reaction.
These various episodes were rehearsals for the Fed’s extreme responses to the global financial crisis of 2007-2009 and the crash of 2020. Either way, it created a dizzying array of new credit facilities for distressed banks. He channeled finance into troubled corners of the economy. It has accepted a wide range of securities, including corporate bonds, as collateral. It has allowed large companies to fail – most importantly, Lehman Brothers. And when the markets started working again, they gave way to much of their support.
Such intense interventions have prompted a rethink of ethical stakes. In the 1970s the concern was over-regulation. Instead of making the financial system safer, policies such as capping deposit rates have driven activism to shadow lenders. Little by little, the regulators have eased restrictions. But after the financial crisis, the pendulum returned to regulation. Large banks must now hold more capital, limit their trading and undergo regular stress tests. Tougher support from the Fed has come with tighter restrictions.
In this context, the government’s response to the Silicon Valley bank looks more like another notch in the wall rather than a radical new design. This is not the first time uninsured depositors have walked away from financial disaster. Nor is it the first time the Fed has allowed banks to fail before offering a credit program likely to bail out similar companies.
However, every notch in the wall also signifies an increasingly broad Fed. In an important sense, her assistance was much more generous than in previous rescues. When extending emergency credit, it is usually conservative in its collateral rules, using market rates to value the securities that banks are handing over for cash. Moreover, it is intended to lend to affluent companies only. This time, however, the Fed accepted government bonds at face value, even though their market value had fallen sharply. This is amazing. If it were to seize the collateral, it could suffer a loss in present value terms. The program can breathe life into banks that were insolvent in terms of market value.
The Fed does not want to make the latest changes permanent. It limited its own loans to just one year — long enough, officials hope, to avert a crisis. If they get what they want, calm will eventually return, investors will shrug their shoulders and banks will get back to work without the need for Fed support. But if they don’t and more banks fail, the Fed will be left with underwater assets on its books, absorbing the financial damage that would otherwise have come to the market. A lender of last resort risks becoming a loss maker of first resort. ■
Read more from Free Exchange, our column on economics:
Emerging Market Central Bank Experiments Risk Reigniting Inflation (March 9)
Lawsuit against Google hinges on antitrust ‘mistake’ (March 2)
What would the ideal climate change lender look like? (23 February)
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