Markets are Asking: So What Part of No Did You Not Understand?

The crisis of 2008 made clear that wholesale funding markets for banks are inherently unstable. In the absence of extraordinary central bank action it is likely that this method of bank funding would have been wiped out by the market. The question this raises is whether the market for financial commercial paper should be wiped out. That is, is it such an unstable funding source that the economy as a whole is better off without it?

Note that I am not asking (yet) whether the central banks should not have intervened in 2008 or today to protect wholesale funding markets. I am asking what should have been the long-term plan after the 2008 intervention — and what should be the long term plan after today’s intervention.  I am asking why we are seeing the same problem arise, when there were 2-3 years of relative stability in which to move away from this reliance on wholesale funding.

The fact that a form of funding that was rejected by the market in 2008 was approved by regulators in 2011 is frightening.  The fact that many of the largest money market fund providers are still trying to get away with selling generic “prime” funds and filling them with financial commercial paper is frightening:  where are the money funds that have non-financial exposure only?  Where are the money funds that offer (taxable) US exposure only? Why are our money fund choices so limited?

As far as I can tell the history is pretty clear:  Once there has been a bailout on the scale of what took place, long-term financial stability is best served not just by announcing an end to the bailouts, but by acting on that announcement when, inevitably, the market challenges your will.  Holding the line both shakes the financial system to its core and, simultaneously, creates the faith that this is a financial system with central bankers who know how to do their jobs.

What events am I thinking of?   The Bank of England’s bailout of the Dutch banking system in 1763, followed by its refusal to bail it out in 1772 (when the cause of the crisis was speculation).  (I happen to think that this is turning point when the center of the European economy switched decisively from Amsterdam to London, but I digress.)  The Bank of England’s bailout of the bill brokers (mostly Overend) in 1857, followed by its announcement not to support them in the future, and its decision in 1866 not to support them in a crisis.  Watching the structure of the financial system shake to its foundations was probably the impetus that drove Bagehot to write Lombard Street — and to write approvingly of the Bank of England’s decision not to support Overend.  Observe how robust the British financial system was when it came out of this crisis; Britain had decades of stable banking, precisely because the banks and shadow banks (i.e. bill brokers) were scared of the central bank.

History of course is not destiny.  It should be possible for regulators to read the events of 2008 and force the changes that the market is demanding without the economy experiencing another major financial failure that shakes the financial system to it’s foundations.  It will, however,  require strong-willed regulators who are capable of demanding changes in our financial structure that will most likely have the effect of significantly reducing the profitability of banks.  The question is whether the regulators here and in Europe are up to this job.  I certainly hope so, but the continued reliance of banks on wholesale funding is a very bad sign.