Unless there is a major change of direction among global economic and financial officialdom, we are at risk of ending up with a world in which liquidity provision is privatised and insolvency risk for banks is socialised. This would be the exact opposite of what makes sense: solvency is (or should be) a private good and liquidity is (or should be) a public good.
Soft budget constraints for the private financial sector
The defining characteristic of a market economy is hard budget constraints: you are responsible for what you owe. No bail-outs. If you cannot pay what you owe, you default on your debt, painful consequences follow: insolvency, loss of collateral, liquidation of enterprises and their assets, recourse to other assets and income streams of the non-performing debtor and, in the old days, debtors prison or debt slavery.
Hard budget constraints provide the key incentive against excessive risk taking and deliberate financial incontinence. Janos Kornai described at length, in Economics of Shortage, his classic work on the internal contradiction of central planning, how soft budget constraints became a defining feature of a centrally planned economy and were central to its astonishing inefficiency and eventual downfall.
Following the confirmation of the already widespread suspicion that large banks and other complex financial institutions were deemed too big, to complex, too interconnected, too international or too politically connected to fail, the (large-scale) financial sector in the overdeveloped world is now characterised by the soft-budget constraint pathology identified by Kornai. Profits go to shareholders, top managements and other insiders. Losses are socialised. What should be the private good of capital and resources devoted to enhance the solvency of private financial enterprises, is now publicly provided – and over-supplied.
Requiring banks and other systemically important financial institutions with high leverage and serious asset-liability mismatch as regard duration, liquidity, currency denomination etc, to hold more capital, to obey leverage ceilings and to write living wills will mitigate but not materially alter this dreadful perversion of a market economy. This can be sorted out and excised only through the creation, on a global basis, of strict special resolution regimes (SRRs) for systemically important financial institutions. Combined with prompt corrective action (PCA) before disaster strikes, an SRR can, technically, turn our financial sector back into something that belongs in and sustains a market economy instead of a form of communism for the rich and well-connected.
I doubt whether an ex-post SRR cum ex-ante PCA would be implemented and enforced even if it were on the statute books. There are two reasons for my scepticism. The first is the fact that even if every individual national regulatory authority is keen to impose an SRR-cum-PCA, there will be no progress unless there is international coordination and cooperation in the design and enforcement of the SRR. That is, despite G20 and IMFC rhetoric, unlikely.
Second, even if we had a uniform and well-designed global SRR, it probably would not be implemented to the detriment of the largest and most politically influential financial institutions. This assertion is based on the observation that the US did have a perfectly adequate SRR for commercial banks whose deposits were insured with the FDIC. It is used all the time for financial restructuring or liquidating smaller private banks. It was not used when Bank of America and Citigroup were teetering on the edge of the abyss. I interpret this as consistent with the view that the same regulatory, legislative and executive capture that prevented the creation of a proper SRR with proper PCA in so many cases, also prevented the implementation of those SRRs that did exist.
Will we see early forceful and effective intervention by regulators and supervisors during the next credit and asset market boom and bubble – before things get completely out of hand and a nasty bust is inevitable? Possible but not likely. It will take a confident, strong and independent regulator/supervisor to do, through monetary, administrative, regulatory or quasi-fiscal actions, what William McChesney Martin, Jr. believed to be the central function of the Fed: “to take away the punch bowl just as the party gets going”.
The Fed and most other regulators have singularly failed to take away the punch bowl just as the asset market and credit party got going, with central banks myopically focused on the behaviour of consumer prices (and in the US real economic activity). Of course, the official policy rate is a near-useless instrument for restraining excessive credit growth and asset price inflation. But the Fed had other instruments that could have been used but were not, including open mouth operations, increases in margin requirements, tightening of collateral standards in repos and other market operations and interventions in the mortgage markets where the Fed has special regulatory responsibilities. It is also astonishing that no central bank or regulator (other than the Banca d’España) innovated in the areas of countercyclical capital requirements or provisioning or countercyclical maximum loan-to-value ratios in the residential mortgage markets.
Will things be different during the next boom/bubble? The next credit and asset market boom will generate massive profits and generous tax revenues. The same phalanx of lobbyists will again descend on regulators, legislators and members of the executive branch of government. New and exciting financial instruments -superprime lifegages perhaps – will be demonstrated by highly paid hirelings from academia to have unprecendented potential for diversifying, sharing and extinguishing risk. It will be different from every other boom in the past. It will be a truly sustainable euphoria – a high for humanity. And the regulators/supervisors will be convinced, seduced, intimidated or co-opted. Of course, as has just been demonstrated so beautifully by Carmen Reinhart and Ken Rogoff in their great book This Time is Different: Eight Centuries of Financial Folly (Princeton University Press, Princeton and Oxford 2009), it is never different.
The unnecessary and undesirable private provision of the public good of liquidity
Unlike solvency, which is or should be a private good that has been provided publicly and socially inefficiently by the state, liquidity, which can be provided or hoarded privately, is a public good that ought not to be provided privately but by the central bank. In the UK, the FSA has announced measures requiring UK banks to hold significantly more liquidity. Currently, banks and building societies in the UK hold about £280 bn worth of cash and government bonds from countries deemed to be solvent (yes there are some left, apparently). The FSA wants this liquidity buffer to be increased by at least one third, and possibly by more. In addition, reliance on wholesale market funding will have to be cut by at least 20 percent: deposits good, wholesale funding bad. There is a grace period – so as not to depress bank lending even more, these bigger liquidity buffers will only have to be achieved when the economy recovers.
This is bad economics. Liquidity is not a thing – not something wufting around in the ether. Liquidity is a multi-demensional property of assets. The degree of liquidity of an asset (real or financial) depends on (a) the speed with which it can be sold (b) the transactions costs incurred in a sale (as measured, say, by the bid-ask spread) and (c) the spread between the realised price of the security and its fair or fundamental value. These three characteristics are of course not independent.
The degree of liquidity of a financial instrument depends on confidence and trust. These are more easily undermined when the instrument is complex and poorly understood by one or both sides of the market. But even when there is no material asymmetric information, confidence and trust can and do wax and wane. Sometimes they vanish completely and the financial instrument cannot be sold at any positive price. It’s clear that the liquidity and solvency are closely related. Financial instruments issued by parties of doubtful solvency are unlikely to be highly liquid. For that reason, the liabilities of governments that are deemed to be fiscally continent are likely to be highly liquid. The legal tender liabilities of the central bank, an agency of the state, are among the most liquid instruments in the world.
This is why central banks have historically been the suppliers of funding liquidity to banks and other financial institutions that find themselves frozen out of their normal funding markets (say because of a bank run on deposits or because of a seizing up of wholesale funding markets) and that don’t have sufficient liquid assets to cover the funding gap. This lender of last resort (LLR) function of banks has been well understood since Bagehot wrote his classic book Lombard Street 136 years ago. Strangely enough, central banks even today tend not to engage in unsecured lending to banks and other private institutions. They have been willing to lend against collateral that may have been worth less than the paper the ownership claims were printed on, but formally unsecured lending remains anathema. It clearly makes sense to relax this taboo, at the same time that the convention is established that the Treasury provides a 100% guarantee for any default-related losses suffered by the central bank.
This is also why, in the crisis that started in August 2007, central banks have gradually learnt to provide market liquidity to support financial instruments that are normally traded in quite liquid markets, but that have become illiquid as a result of an erosion of trust and confidence. This market maker of last resort (MMLR) function of the central bank can involve the central bank accepting a wider range of collateral, including illiquid collateral, in its lending operations (repos or any of the myriad facilities created by the Fed, the ECB and the Bank of England). It can also involve direct purchases of private assets, including illiquid private assets by the central bank, say through reverse auction mechanisms of various kinds.
When there is a crisis of confidence and trust, central banks should act aggressively as lenders of last resort and market makers of last resort and provide any amount of liquidity demanded, albeit at a price. It may be possible for private banks to hold enough liquid assets (government debt, effectively) on their balance sheets to survive even a major liquidity crunch without recourse to the central bank. But that would be socially inefficient. Banks are meant to intermediate short liabilities into long-term assets, and frequently into long-term illiquid assets. It’s what their raison d’être is. Banks should hold enough liquid assets to meet the needs of the trade and the random inflows and outflows of normal times, when confidence and trust are high. When confidence and trust in an individual bank are low but the system is sound, an individual institution may be able to access credit lines and other forms of liquidity insurance with private counterpaties. But when confidence and trust in the system as a whole are low, there is no efficient solution involving just the private sector. The banks then rightly turn to the central bank for funding liquidity or market liquidity.
Providing liquidity is what God made central banks for. Their domestic currency liabilities have the highest degree of liquidity of any domestic-currency-denominated financial instruments. Central banks should be the providers of emergency liquidity of first resort – at a price. If private banks have to hold enough government debt during good times to allow them to survive a systemic liquidity crunch during bad times, they are engaged in a privately and socially inefficient and dysfunctional form of self-insurance, rather like China and some other emerging markets who stockpiled huge liquid reserves. It is individually rational in the case of China, because they don’t trust the IMF to come to their aid on acceptable terms and because there is no other market maker of last resort or lender of last resort for sovereign nations.
But the same self-insurance behaviour is not socially rational if there is a potential lender of last resort and market maker of last resort. And for filling a funding gap involving domestic-currency instruments, the domestic central bank is the obvious supplier of emergency liquidity. Clearly, this does not apply when there is a foreign currency funding gap as a result of liquidity crisis. As we saw in Iceland, a domestic-currency lender of last resort is little use when their is a dearth of liquid foreign-currency assets. But the proposals of the FSA require the banks not only to hold foreign currency liquidity well in excess of normal requirements, but also domestic currency liquidity. That represents a socially inefficient use of bank capital.
The response of the City of London to the proposals of the FSA were disappointingly economically illiterate. Commentators objected to the requirement to hold significantly more liquid assets on the balance sheet because they said it would undermine the international competitive position of the City of London. So should they be happy if the same increase in liquidity requirements were to be imposed uniformly across the world? No, it still would make no sense, because hoarding of domestic currency liquidity by banks is a waste of bank capital and a socially inefficient use of scarce bank balance sheet headroom. Banks should lend to households and to the private non-financial business sector. They should not be forced to make funding easier for the Chancellor exchequer. Banks should only be required to hold enough domestic currency liquidity to meet normal demands when markets are orderly and funding liquidity is not impaired by lack of confidence and trust.
The authorities should not waste their limited organisational capital to force banks to provide inefficiently the public good of liquidity when confidence and trust are low. They should instead focus on ways of enforcing hard budget constraints on banks – to confront them with the realities of insolvency in a way that separates shareholders, unsecured creditors, boards and managers from their investments while leaving the bank as a functioning organisation capable of continued intermediation.