[Note: This is the last of a series. I recommend reading the series in order — this will require clicking here or on the “Serial1” link under categories, scrolling down to the first post (#1-1) and reading up the blog from there. I’m experimenting, so the series available to read in pdf format on Scribd for a nominal fee. The printable pdf is also available.]
The financial system is built on credit – but not just on credit in general: the financial system is built on the credit of banks. Whether we are talking about checking accounts, or the asset-backed commercial paper and repurchase agreements that money market funds invest in, the liquid assets that keep our economy running depend crucially on trust in banks. Without this trust, no one would deposit their money with a bank and money fund managers would not buy the commercial paper guaranteed by a bank or the repurchase agreements sold by a bank.
Currently Bear Stearns, Lehman Brothers, AIG, and all the other financial failures have profoundly damaged the trust on which our financial system is built. The question we face now is what actions should be taken to rebuild the foundations of that trust.
Some hark back to Franklin D. Roosevelt and argue that he faced a similar problem and addressed it effectively by establishing the Federal Deposit Insurance Corporation, a government agency which charges banks a fee in order to protect depositors from losses. Some claim based on this model that the role of government in the financial system is to insure creditors against losses on bank liabilities in order to prevent bank runs from causing financial institutions to fail.
This approach oversimplifies our financial history. Recall that when the FDIC was established the economy had just been traumatized by a rash of bank failures so extreme that fully one-third of all the banks in the United States had closed over the previous five years. Market forces were not stabilizing the economy. The financiers had tried and failed to rebuild trust. So trust in government was the economy’s last hope – and it worked.
In the current crisis, market forces have never been allowed to operate. At every hint of instability the government has stepped in to jerry-rig a solution. Far from turning to the government as a last hope, our banks have been relying heavily on government intervention for the whole of the past two years. Thus, the challenge we face is of a completely different nature from that faced by Roosevelt: Our banking system is not composed of the traumatized survivors of a catastrophe, it is instead composed of spoiled children who are scared of the risks inherent in leaving home to go earn a living for themselves.
If the policy goal is to extend Roosevelt’s financial market reforms of the 1930s to the present day, then the solution is to treat repurchase agreements and swaps as securities that are subject to requirements similar to those imposed on stocks, bonds, futures and options in the 1930s. Had large scale repo and swap markets existed in the 1930s, they would almost certainly be governed today by self-regulatory organizations that are subject to the supervision of the SEC.
Financial systems exist to manage credit risk, to evaluate borrowers and direct funds to those who are most likely to be both capable and willing to repay their debts. For this reason, it is neither possible nor desirable to protect a financial system from losses due to credit risk. When the safe harbor exemptions were passed, legislators were told that banks couldn’t manage the credit risk of derivatives and needed special privileges so that they could use collateral to protect themselves.
Over time a collateralized interbank lending system developed. Forgetting their Keynes, banks put their trust in collateral to protect them against losses. Collateral allowed them to do business with other banks which they knew were not well-managed. It made them confident that they didn’t need to provision for losses. Weak firms maintained a deep web of connections with the rest of the financial system, which was itself overleveraged. And then in March 2008 the banks came face to face with the fallacy of liquidity. As they suddenly realized that collateral could not protect them if one of their own failed, they withdrew their credit lines causing the very failure that they feared.
The solution to our current problems is to recognize that trust in the banking system can only be restored when we have banks that are no longer dependent on collateralized interbank lending, but instead are willing to trust their colleagues. Such trust – or credit – founded on strong balance sheets and good risk management is the only secure foundation for a financial system.
 See for example Gary Gorton, 2009, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007” http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882&rec=1&srcabs=1404069
 Ben Bernanke, 1983, “Nonmonetary effects of the financial crisis in the propagation of the Great Depression,” American Economic Review, 73(3), p. 259.