The potential for financial crises can only be mitigated, never eradicated. Few institutions are more vital in resolving a crisis than the lender of last resort. I thought reformers like Elizabeth Warren understood this necessity, but I may have been wrong.
Senators Elizabeth Warren and David Vitter have introduced The Bailout Prevention Act of 2015. The bill would restrict access to emergency lending by the Federal Reserve and pressure the central bank to lend at steeper rates in a crisis. According to former Fed Chairman Ben Bernanke, it would undermine the Federal Reserve’s role as lender of last resort. Bernanke’s argument is compelling:
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.
The stigma problem is very real, with many historical illustrations. When the BBC announced in 2007 that the British lender Northern Rock had received a loan from the Bank of England, for example, a severe run on the lender began almost immediately. Ultimately, the government had to take the firm over.
The Warren-Vitter legislation would create an insuperable stigma problem. (It has other drawbacks as well, but my focus here is on stigma.) First, the requirement that solvency analyses be released immediately (or quickly) would publicly identify any potential borrowers. No borrower would allow itself to be so identified, for fear of the inferences that might be drawn about its financial health. Second, the five percentage point penalty rate requirement would remove any doubt that those borrowing from the central bank had no access to other sources of funding, further worsening the stigma problem. (A penalty rate was not a problem in [Walter] Bagehot’s era, because, unlike today, all lending by the central bank was strictly confidential.) Moreover, because borrowers would know that the program could be terminated in thirty days if Congress didn’t approve, the benefit of borrowing from the central bank would be limited. Because borrowers would not willingly participate, broad-based lending programs (which Dodd-Frank intended to preserve) would not work, and we would have lost a critical weapon against financial panics.
The approach of Senators Warren and Vitter, Bernanke said, is “roughly equivalent to shutting down the fire department to encourage fire safety.” It would be far better to improve the fire code, which has already changed since 2008:
The Fed intervened in the cases of Bear and AIG with great reluctance, doing so only because no legal mechanism existed to safely wind down a systemic firm on the brink of failure. A key element of the Dodd-Frank financial reform bill, passed in 2010, was to provide just such a mechanism—the so-called orderly liquidation authority, which gives the Federal Deposit Insurance Corporation and the Fed the necessary powers to put a failing firm into receivership without creating financial chaos. (By the way, a great deal of progress has been made in implementing this authority and preparing for the possible failure of a systemic firm; see these recent remarks by FDIC chairman Martin Gruenberg.) With the creation of the liquidation authority, the ability of the Fed to make loans to individual troubled firms like Bear and AIG was no longer needed and, appropriately, was eliminated.
If the liquidation authority is not yet adequate, reformers should demand its enhancement. But undermining the Fed’s role as lender of last resort is backasswards. It leaves me baffled as to what lessons were learned by Senator Warren from the financial crisis.
There are reasons to doubt the stability of the financial system, as Martin Wolf has argued. But when reformers get the diagnosis wrong, they are far more likely to screw up the remedy.