On banks and the provision of liquidity

William Dudley wants to permanently expand the role of the lender of last resort well beyond the commercial banking system.  He argues that most financial firms can face runs and that it is the role of the central bank to eliminate the possibility that a solvent financial firm faces a run.

I think this view is founded on a misunderstanding of the nature of liquidity and thus of the role of the lender of last resort. Liquidity is created when creditworthy borrowers have access to loans.  While a well functioning economy requires a government that is creditworthy and will protect the value of its currency, a well functioning economy also requires ample access to credit on the part of the populace.  Both public and private liquidity are essential to the operation of a dynamic economy.

Banks provide liquidity to the private sector.  Private sector liquidity exists because banks know how to evaluate and monitor the credit of borrowers.  When banks make loans, they create money.  That is why bank deposits are an important component of the money supply.

The value of bank money depends fundamentally on the quality of the banking system’s lending process.  If the banks make enough bad loans to drive them into bankruptcy, their depositors will lose money and there will be a loss of confidence in the banking system.  In a worst case scenario depositors lose all faith in the banking system and the private provision of liquidity collapses — and the well-functioning economy along with it.  For this reason a banking system must be sound:  banks must on the whole make profitable loans.

Because in a normal banking system some banks fail every year and some depositors lose money every year, there is a risk that depositors will overreact to normal events and lose faith in the banking system even though the banking system is making good loans and is fundamentally sound.  In this environment the private provision of liquidity can be protected by a central bank policy of lending to solvent banks against sound collateral.  These loans allow the solvent banks to honor their obligations to depositors, even though the loans they made are still outstanding.  In this situation the central bank acts as a pressure valve to prevent the natural vagaries of a system of private liquidity provision from destroying the system.

Thus the government has several important roles to play in the provision of liquidity.  By maintaining fiscal and monetary discipline the government ensures that the value of money is reasonably stable and that the government is not extracting (too much) value from the private provision of liquidity.  It also protects the system of private liquidity provision by protecting well-managed banks from a run by depositors.

This public-private partnership in the provision of liquidity is delicately balanced. It requires the central bank to have the discipline to refuse to provide liquidity to any banks that do not have sound lending practices.  Supporting a bad bank is one of the most dangerous actions a central bank can take, because it makes bad lending profitable and thus undermines financial stability.  In short the central bank must act with the understanding that short term instability is the price that must be paid for long-term financial stability.  The lender of last resort is a crucial pressure valve that protects the system, but it cannot be relied on too heavily — or just as in a physical system where the pressure valve is always open — it will stop playing the role of a safety mechanism and will instead act to permit the buildup of destabilizing forces.

Furthermore, banking like all industries is constantly in flux with new products and new practices appearing all the time.  For this reason it is the bankers who have enough information to evaluate their business practices and it may be impossible for the central bank to gather enough information to determine whether a particular bank is solvent in the midst of a crisis.

My concern with William Dudley’s view of the role of the lender of last resort is that his policy would turn a safety valve that ideally is almost never used and was designed to protect the commercial banking system into a reliable path of travel for the whole financial system.  Unless he wishes to propose some alternate backup mechanism that can fill the traditional role of the lender of last resort, I view the proposal as destabilizing over the long term.

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