The Problem of Collateral

There are two major problems with collateralized interbank lending.  The first is that there’s no reason to believe that collateral will function to protect the lender in the event that a major bank fails and the second is that the shift from unsecured interbank lending to collateralized interbank lending is likely to have a contractionary effect on the money supply.

At least since Keynes, there has been general recognition that the analysis of aggregate economic activity and the analysis of an individual’s economic behavior require different tools.  The reason for this is simple, individuals can often be viewed as price-takers, who have no effect on the aggregate economy.  Effectively micro-economic analysis abstracts from the problem of liquidity, whereas macro-economic analysis must confront this problem directly (which is not to claim that the dynamic stochastic general equilibrium models that dominate the field of “macroeconomics” today  typically do confront the problem of liquidity, but that’s a different debate).

Alea points out (see comment here) that Basel II discourages banks from lending to each other on an unsecured basis.  The fallacy that regulators appear to be engaging in when they favor collateralized interbank transactions is precisely the fallacy that Keynes criticized forcefully in Chapter XII of the General Theory:

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.

Regulators are failing to distinguish between what is optimal for the individual bank and what is optimal for society.   Liquid assets are supposedly “safe” – but for the problem that liquidity itself is inherently ephemeral.  How precisely do the regulators imagine that collateral posted by a systemically important financial institution (SIFI) is going to protect the lenders?  If the SIFI goes down, there is, in the absence of central bank intervention, a fire sale.  And if they’re counting on central bank intervention to make it possible for collateral to function to protect the borrowers from losses (e.g. via a PDCF or TSLF), why not just rely on traditional central bank lending to banks in a crisis?  What precisely does collateral posting by a SIFI add to the existing system of central bank crisis support for regulated financial institutions?

As discussed in my previous post, the biggest problem with allowing SIFIs to post collateral to one another is that it discourages them from restricting credit to banks that are poorly managed.  By discouraging normal market forces from working to limit the growth and interconnectedness of bad banks with the rest of the financial system, a collateralized interbank lending regime places an enormous burden on regulators to both identify and shrink a bank that has deep connections with the rest of the financial system.  Arguably collateralized interbank lending places an impossible burden on regulators.

The second major problem with shifting from a system of unsecured interbank lending to a collateralized banking system is that in the process of purging the money supply of unsecured debt, the money supply may well have to shrink to the size of the collateral base. Precisely because the shift to collateralized interbank lending creates strong contractionary pressure on the money supply, there is a call for governments to create “safe” assets – that is to increase the size of the collateral base to accommodate the money supply.

Why not call on the banks to create safe assets by underwriting loans carefully?  Such loans after all have historically been all that is necessary to back the money supply.  Perhaps the answer to the question is that “safe” privately issued loans aren’t part of the economic model being used?  I sometimes feel that macroeconomic models that treat government as the social planner’s deus ex machina have so infiltrated some economists’ thought processes that they actually expect a real world government to successfully play the role of a benevolent deity.

If the financial system is so fundamentally unsound that the banks should not be extending unsecured interbank credit each other, the government is not going to be able to do anything to save it.

Related Posts:
What banks do:  monetize human capital
What is capital?
Comparing bankers past and present 

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