Dismantling the economy’s legal infrastructure V-5-e: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 5: The growth of leveraged buyout loans

A consequence of the special protected status granted by the US government to the money center banks was that even after the LDC crisis they continued to raise money with ease and at low cost relative to smaller banks on both international and domestic markets. Thus, despite their demonstrated inferiority to smaller banks in managing their loan portfolios, vast sums were available – due only to their government-supported status – for them to lend. Furthermore, due to that same protected status, these banks would have the capacity to extend their loans indefinitely. Under these circumstances it is not surprising that money center banks sought out a new source of earning assets to replace the much reduced LDC loan market. Syndicated lending turned to “leveraged loans,” that is, the loans that are used to load corporations up with debt in leveraged buyouts.

Recall from a previous post that the Small Business Investment Incentive Act of 1980 had shifted the SEC’s mandate from one of protecting investors (both wealthy and non-wealthy) to one that also promoted the capital formation of small businesses. This was adopted in the name of helping the small businesses that were struggling due to the shift to “market-based lending” that favored big banks and big firms at the expense of SMEs. This law encoded into legislation the concept of the “accredited investor” and allowed large classes of investors to be exempt from the protections that had in the past been held to cover even the wealthy. Subsequently, in 1980 the SEC promulgated Rule 506 of Regulation D, which unlike all the rules that preceded it, permitted firms to use private offerings to raise an unlimited amount of funds from an unlimited number of accredited investors as long as the there was no “general solicitation.” (In the past, all of the SEC’s private offering rules strictly limited either the amount that could be raised or the number of investors from whom funds were raised.)

Regulation D made the leveraged loan market possible. Whereas junk bonds are issued in public offerings that meet the stringent requirements of SEC registration, leveraged loans are issued in private offerings and are subject to only a very limited set of investor protections. According to the SEC the adoption of Regulation D was motivated by a desire to promote the capital formation of small businesses. Ultimately, however, the “small businesses” that were able to grow due to the creation of the leveraged loan market were financial firms, not the non-financial SMEs that the legislators had in mind in when they passed the 1980 Act.

Private equity firms (also known as leveraged buyout firms) would use leveraged loans and a technique known as the “leveraged buyout” to either facilitate a management buyout or a hostile takeover of a corporation. In a management buyout private equity assists a corporation’s management in the purchase of the corporation’s assets from the owners of the corporation, subject to a majority vote of the corporation’s shareholders. Because the corporation’s management has a fiduciary duty to the firm’s owners and management’s interests are directly in conflict with the shareholders’ interests in these transactions, such transactions may be motivated by managers and private equity professionals who are arbitraging weaknesses in the law governing corporate management’s duty to shareholders.

In a hostile takeover the private equity firm is able to literally force debt on a corporation whose management believes such debt is not in the interests of the corporation. A hostile takeover is typically executed by the private equity firm making a conditional offer to shareholders to purchase their shares at a price above the market price – the condition is that the offer will only be executed if enough shareholders accept to give the private equity firm control.

To explain fully how buyouts operate it is important to review the well-established effects of taking on leverage. When an equity holder leverages her investment by borrowing to fund the investment, she increases the risk of her investment making it more likely that the project will go bankrupt and she will lose money, but at the same time in the event that the project makes money she increases her potential return. Because a firm is unlikely to go bankrupt immediately upon increasing its debt load, the immediate effect of leverage on the share price of a corporation is often an increase in the price. The cost of that increase is however the increased price volatility inherent in a leveraged investment – and the increased likelihood of a total loss or bankruptcy.

Both management buyouts and hostile takeovers typically take place in an environment where share prices are low relative to the value of firm assets, since this is the environment in which an increase in leverage is likely to result in a short-run positive effect on the share value. Both types of leveraged buyout then have the effect of paying an immediate higher return to current shareholders who are bought out and who give up their claim to the firm’s assets and the possibility of a future even higher return. They also both have the effect of significantly increasing the likelihood that the firm in question goes bankrupt.

What makes these deals of questionable economic value is the fact that the private equity firms (and in some cases the corporate managers) who organize these transactions are not simple equity investors in the new firms – and their incentives are typically not aligned with that of making sure that the firm that has been loaded up with debt will continue to be a going concern. Instead these organizers of leveraged buyouts are able to extract upfront fees and payment from the transactions, and thus have an interest in keeping a flow of leveraged buyouts going even if the end result will be a rush of bankruptcies, layoffs, and economic dislocation (Applebaum & Batt 2016).

Thus, the Small Business Investment Incentive Act and Regulation D had the effect of creating a leveraged loan market that was arguably designed to enable private equity firms to arbitrage weaknesses in the legal and regulatory structure governing corporate governance. Where do the money center banks fit in this picture? This new lending market was opening up just at the time that the money center banks were finding that they needed to cut back on the LDC loans, as the borrowers were close to default. The extraordinarily cheap funds that were available to the money center banks due to their government-guaranteed status could be put to use in the syndication of the leveraged loans that financed private equity and corporate buyouts.

Consider this new perversion of the financial system: The money center banks use their access to funding which due to government support was available at low cost in almost unlimited amounts in order to promote the development of a new type of financial firm which specializes in arbitraging weaknesses in the law governing US corporations for the purpose of loading US corporations with debt. The end result has been a massive leveraging of US corporations – even in circumstances where corporate management believes the debt is not in the long-run interests of the corporation. On the one hand, the threat of hostile takeover pushes corporate management to take a less and less conservative approach to debt, and, on the other, money center banks and private equity firms are able by charging fees on this process to profit generously from their arbitrage of corporate law. Effectively, the extraordinary leveraging of corporate America is a consequence of government-guarantees provided to money center banks and the banks’ search for a way to profit off of this this vast source of funds.

It’s worth pausing a moment to compare the post-Bretton Woods financial environment with the one that existed at the height of Bretton Woods. When banks were at risk of failure and did not have access to significant sources of so-called “market-based” funding, they had to behave like traditional banks that could only keep their liabilities in circulation by lending – prudently. There was in this traditional model a tight connection between lending, the circulation of bank deposits, and bank funding. This tight connection was broken by market-based lending with the 1970s growth of the Eurodollar market and the commercial paper market. Suddenly the largest banks were able to finance themselves on markets (in fact as we have seen due to a government guarantee) and no longer needed to worry about lending in order to put deposits into circulation. Indeed, due to the government guarantee the incentives for these banks to lend prudently had declined dramatically. They turned to lending to foreign countries and to lending on a term basis to corporations in a way that served to increase debt on corporate balance sheets and the flow of funds from nonfinancial corporations to the financial sector without in fact having much of a transformative effect on the activities of the corporations. In short, the growth of market-based lending is closely associated with the growth of bank lending, that is not productive, but instead seeks out borrowers who can be induced to make interest payments as a form of tithe to the financial sector. Indeed, this transformation of banking post-Bretton Woods may explain the puzzlingly high cost of financial intermediation in the current era (Philippon 2012; see also Philippon 2015).

LINKS
Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois
Implications

Dismantling the economy’s legal infrastructure V-5-d: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 4: The LDC crisis

The LDC Debt Crisis

By the end of 1981 Paul Volcker had demonstrated success in controlling inflation – having allowed the Federal Funds Rate to rise over 20%. 1982 would, however, prove to be a difficult year for financial markets. July saw two significant bank failures, one Italian bank and one US bank. And then there was the LDC debt crisis: in August the Mexican government defaulted on its debt, followed by a series of additional defaults.

The Italian Banco Ambrosiano roiled the Eurodollar market when it failed and neither the Italian nor the Luxembourg government was willing to support the Luxembourg branch of the bank. The losses this policy imposed on the Eurodollar market once again caused two-tier pricing in the market to the disadvantage of small banks (Kapstein 1994: 54).

Penn Square Bank was an Oklahoma bank that financed oil and gas exploration and after its failure turned out to have been engaged in fraud (Sprague 1986: Ch. 6). Penn Square had sold $2 billion in participations in its oil and gas loans to other banks, so once again the Federal Reserve pushed the FDIC to protect the creditors of the bank. Only after the FDIC made clear the extent of the fraud and the fact that a sale of the assets to another bank would be likely to destabilize the purchaser did the Fed concur that the only legal alternative was a liquidation of the bank. The bank was closed on July 5, 1982. Its books were in such disarray that it would take the FDIC almost a year to come up with an estimate of the losses to uninsured creditors of the bank of 35%. The Penn Square liquidation would play a role in the failure of the seventh largest US bank due to Continental Illinois’ $1 billion in exposure to this fraudulent bank.

Mexico was an oil-exporting country and the decline in oil prices that began in 1981 and continued through early 1983 eroded its capacity to carry dollar-denominated debt (Broughton 2001: 283).[1] The country’s problems were exacerbated by the fact that it maintained a fixed exchange rate – that was growing ever more obviously unsustainable, and thus Mexico experienced massive capital flight in the years leading up to the 1982 debt crisis (Kapstein 1994: 84, 88). Capital flight, of course, just exacerbated the pressures driving a devaluation. The immediate cause of the crisis was, however, the decision by US money center banks not to roll over a substantial principal payment that was due on August 16, 1982 – despite having agreed to a significant increase in lending just seven weeks earlier (Boughton 2001: 286, 290).

In the period since the second oil price shock, the exposure of the money center banks to LDC debt – and Mexico in particular – had been increasing, so that by the end of 1981 LDC loans made up more than 10% of their assets and 2.6 times their capital (FDIC 1997: 196, 199; Boughton 2001: 283-86). A Mexican default would force the biggest banks in the US to recognize significant losses, and almost certainly result in one or more bank failures – especially immediately following the losses associated with the Penn Square liquidation. Once again, the stability of the international financial system was at risk – just two years after the First Pennsylvania bailout.

Arthur Burns had foreseen this danger (see previous post) and Paul Volcker (1980: 21, 27, 31-32) too had expressed concern in early 1980 that having “muddled through” the first oil price crisis by relying on the lending capacity of the commercial banking system without sufficiently addressing the underlying problems, the temptation would be to continue along the same path, “overloading the commercial banking system” and failing to serve the long-run interests of either borrowers or lenders. Both Fed Chairmen believed that an effective solution would require an expansion of IMF lending and more balanced emphasis on adjustment to the new cost of oil in addition to financing.[2]

Volcker (1980: 26) also observed, however, that adjustment in the developing countries would mean a decline in developed country exports – and a shift in the current account deficit toward the developed countries. For this reason, it is perhaps unsurprising that other US policymakers – notably not those involved in bank supervision – were actively encouraging developing countries to borrow (Kapstein 1994: 85, quoting Deputy Secretary of State Elinor Constable). In this environment, one begins to understand why the inaccurate euphemism “recycling of the OPEC surplus” gained so much currency (id). This was a way to use language to imply that bank loans to LDCs were just a way of efficiently reallocating resources, while avoiding acknowledgement of the dangers of this massive increase in debt to both the borrowers and the lenders. Bank regulators were naturally focused on the latter, and much less concerned about the effects more prudent bank lending might have on the balance of payments.

When Volcker was giving his speech the Federal Funds Rate had barely breached 17%. He could not have known that it would ultimately take many months of interest rates in excess of 17% to control inflation. (Indeed, this was understood at the time as evidence of a remarkable decline in the effectiveness of monetary policy, Economist 1984: 62.) From the oil-importing countries’ perspective, there was not just an oil “tax” during this period, but also a debt “tax.” Adjustment would have been devastating, and many countries chose to borrow their way through 1981. There was a major difference this time around: whereas the first oil price hike was accompanied by inflation that reduced the real burden of the debt, the “debt” tax instead had the effect of ending the US inflation and thus making the dollar-denominated debt burden that was being taken on heavier than expected.

Why the banks were willing to accommodate the growth of LDC debt during 1980 and 1981 is not entirely clear. In June 1981 Fed Governor Wallich (1981) was publicly calling on the banks to limit their exposure to LDC debt just as Volcker had done a year earlier, but to no effect (GAO 1982). Was the First Pennsylvania bailout interpreted by bank management teams as evidence that the Fed was willing to do “whatever it takes” – a view that shifted only when Penn Square was liquidated? Were the bank supervisors – despite Volcker’s and Wallich’s warnings – not paying enough attention? Did the Fed, or some part of it, have a policy, like that during the First Pennsylvania bailout, of avoiding bank failures due to LDC debt exposure during the Volcker disinflation?[3] Given how clearly the Fed saw the risks in 1980, how publicly the Fed discussed its’ concerns, and the fact that formal capital requirements were developed in this period to constrain LDC lending (Wallich 1981: 13; FDIC 1997: 89), the evidence indicates that the expansion of LDC lending by the money center banks in 1980 and 1981 was a decision made by the banks despite the bank regulators’ efforts to restrain this growth.[4]

Bank management had a responsibility to both shareholders and the bank corporation more generally to run the bank in a responsible manner with a view to future solvency and profits. Given that the seven largest banks accounted for significantly more of the growth in US bank loans to LDCs during this period than the rest of the banking system,[5] there is strong evidence that the credit backstop (improperly labeled “lender of last resort” support) provided by the US to the Eurodollar market had the indirect effect of interfering with the operation of traditional market-based restrictions on this LDC lending. In other words, the presence of moral hazard has to be part of the explanation both for bankers’ willingness to take on excessive exposure to LDC debt and more importantly for these bankers to continue to have access to funding on interbank markets despite their significant and increasing exposure to this debt. Indeed, even if evidence eventually arises to support the view that regulators were promoting the extension of LDC debt during the Volcker disinflation, moral hazard would have to be part of the explanation for bankers’ willingness to comply with such non-economic pressures.

Due to the money center banks’ massive exposure to Mexican debt, in August 1982 the international financial system was put at risk. Prompt recognition of losses on the debt would have caused the failure of seven or eight of the ten largest US banks at the time. To avoid this outcome, the banks were granted regulatory forbearance and given time to earn their way out of their losses (FDIC 1997b: 207). Just when default was imminent, the US government stepped in to prevent it (Boughton 2001: 292-93). The measures taken, however, were stopgaps, designed only to buy time for a longer-term solution to be worked out. Due to the limited resources of the IMF what was viewed as a viable program for restructuring the debt and reforming the economy required a $5 billion increase in private sector loans. While the outstanding loans were concentrated in the money center banks, syndication meant that more than half of the debt was held by about 500 additional banks. The smaller banks had managed their exposures much more carefully than the large banks and stood ready to take their losses – they did not need a bailout. Of course, if the small banks walked away the burden on the large banks of the proposed restructuring would be much heavier, increasing the concentration on their balance sheets (Broughton 2001: 305-07, 312).[6]

The solution to this problem was “officially sponsored concerted lending” (Broughton 2001: 312): the IMF began to meet repeatedly with the Chairmen of the largest banks in order to determine the best way to bring hundreds of banks on board with the extension of new loans. The big banks asked the IMF to help persuade domestic bank regulators to both pressure the smaller banks to participate in the loan extension and also provide regulatory forbearance for bank LDC loans.[7] The money center banks were also able to use the fact that the smaller banks needed to be induced to participate to wrangle very favorable terms from Mexico for the loan extension – which of course the bigger banks with their larger exposures also benefited from (Broughton 2001: 309-11). The net effect would be that the bank creditors would receive large net transfers from the debtor countries, while the official creditors made large net transfers to the debtor countries (Kapstein 1994: 95-96, quoting Sachs 1986).

In short, the money center banks were first able to profit from their aggressive lending practices in the lead up to the crisis, and then to negotiate a restructuring with the Mexican government as representatives of the much more cautious lenders who could easily walk away. This was the effect of forcing Mexico to deal with an officially-sponsored cartel of lenders that was working hand-in-hand with the IMF, which in some cases was even willing to act as an intermediary presenting the bankers’ objections to Mexican regulations to the Mexican government (Broughton 2001: 308). If the Washington Consensus-based austerity policies imposed on the LDCs by the IMF had actually been the formula for economic success that they purported to be, there might have been an excuse for this dirigiste approach to the LDC debt situation. In retrospect, however, it is obvious that these policies served only to strengthen the money center banks at the expense not just of the developing countries, but also of the non-money center banks in the developed countries.

After the Mexican debt crisis, “spontaneous” new lending to Latin America dried up entirely, replaced by “officially sponsored concerted lending” that combined bank and IMF loans with IMF adjustment packages that imposed austerity on the developing countries (Kapstein 1994: 91, 96). Indeed, because the banks were expected to work with the IMF and to promote its adjustment programs, it seems that independent lending by the banks might well have met with policymakers’ disapproval. In the International Lending Supervision Act of 1983 the US (finally) increased its funding for the IMF.[8] With new bank lending slowing to a trickle, and massive outflows from the LDCs to the banks in interest payments, by the mid-1980s the Latin American economies were not just stagnating, they were suffering (Kapstein 1994: 88, 97).

By 1987 the money center banks had largely recovered from the crisis. The developing countries, however, had not. In that year Brazil declared a moratorium on the interest payments on its debt, and the banks began to realize most of the losses on their LDC debt (Kapstein 1994: 99). Only in 1990 did the reality of the developing countries’ economic regression finally result in a policy of debt reduction. In practice, however, the developing countries had to negotiate the Brady Plan reductions with the banks, and the amount of the reduction was generally small (Kapstein 1994: 100-01).

Overall, in the years leading up to the 1982 crisis the capacity of the money center banks to continue to receive market-based funding despite the reckless risks they were taking can be explained only by the moral hazard created by the US policy of protecting bank creditors from losses. That this was distorting the banking system’s capacity to allocate credit efficiently should have been obvious by 1982 when the Mexican debt crisis broke out, as it is a clear cut case of gross mismanagement by the largest US banks. Instead of recognizing that the government-guaranteed funding of the largest banks was undermining the banking system’s capacity to exercise careful judgment when underwriting loans, in the face of abundant evidence to the contrary the money center banks were treated as if they were inherently endowed with good judgment. The result of this experiment was aptly predicted by Bagehot (1873): “aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.”

In addition to the evident moral hazard aspects of the 1982 debt crisis, it also seems to mark a turning point in the relationship between developed country governments and the money center banks. Instead of responding to the banks’ gross errors in lending judgment by disciplining the banks, insisting that management be replaced, that business lines be sold, that the worst-managed banks shrink their balance sheets, the governments entered into a confederacy with the mismanaged banks to extort concessions from the debtors. These debtors who had traditionally borrowed on the London market, where banks had for more than a century been required maintain high lending standards or fail,[9] were completely unprepared for the change in regime. The non-money center banks were being treated as subservient to policymakers and were called upon to make loans “for the good of the banking system,” instead of being treated and respected as independent entities, responsible for their own decisions. Starting with the 1982 crisis, the IMF regularly refused to lend unless its lending was accompanied by new commercial bank loans, and policymakers and bankers were careful to work together and present a united front to debtors (Kapstein 1994: 96).

In short, if in the 1970s the credit guarantees provided on US money center bank liabilities set the stage for the growth of a massive government-supported international financial system on the weak foundation of moral-hazard-ridden bank decision-making, in the 1980s the system evolved so that these same fundamentally compromised banks were treated not just as the partners of official institutions, but as cronies who generally had the right to favorable terms by comparison with those earned by the government. In less than a decade the rot in the international financial system had settled very deep indeed. This set the stage for the Asian financial crisis fifteen years later – and also for the savings glut that was a response to the crony capitalism that lay at the heart of the international financial system post-Bretton Woods.

LINKS
Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois
Implications

[1] Mexico is a clear example of the fact that the LDC crisis was not generated by the “recycling” of oil-based earnings to oil-importing countries.

[2] “Let us not delude ourselves: financial flows cannot fill indefinitely a gap that must be covered by conservation, production, and new forms of energy.” (Volcker 1980: 33).

On the other hand, as Spiro (1986: 141-42) observes, political decision-makers in the US chose not to provide the IMF with enough funds to play the role envisioned by the Fed Chairmen.

[3] Kapstein (1994: 76-77) indicates that the Economist reported that central bankers pushed the banks to extend their loans during this period, but in context it is far from clear that the Economist is making this claim for 1980 and 1981, rather than for the period after the debt crisis broke in August 1982 (Economist 1984: “To make the [IMF’s] case-by-case approach work, several central banks have been ready to twist arms, persuading their commercial banks to keep lending to Latin America. With hindsight they agree that the lending went too far and too fast in 1978-82; foresight warned them that too big a slowdown would make it harder for debtors to service their debt.

Though commercial bankers dislike being bullied by their central banks many admit it was necessary.”)

[4] It is interesting that Volcker (1980: 29) observed that “the record since 1973 has shown that outright defaults by borrowing countries are virtually non-existent,” perhaps indicating that he understood very well that LDC default might be avoided with the help of multilateral institutions like the IMF.

[5] The seven largest banks accounted for 56% of US bank loans to LDCs in 1980 and 60% in 1982 (Madrid 1990: 59; see also FDIC 1997: 199).

[6] On October 15, 1982 with the passage of the Garn-St Germain Act statutory limits on lending to a single borrower were increased to 15% of capital or 25% when backed by collateral. Given the timing this section appears to have been designed to facilitate an increase in commercial bank lending to Mexico and other LDCs.

[7] Thus, when the Economist (1984) discusses central bankers “bullying” the banks to extend their lending to LDCs, it may well be referring to this episode late in 1982 when there is no question that a great deal of pressure was put on the banks to extend their loans.

[8] The same law created congressionally mandated capital requirements for banks and called for international coordination of such requirements.

[9] Indeed, the Baring crisis of 1890 is an apt comparison. When Baring Bros. failed due to reckless lending in Argentina, the managing partner was left impoverished and offered a stipend by a relative who had retired from the firm and had no liability for the losses (Sissoko 2016).

Dismantling the economy’s legal infrastructure V-5-c: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 3: First Pennsylvania bailout

The Bailout of First Pennsylvania Bank

In the last months of 1978 the Iranian Revolution triggered a second dramatic rise in oil prices, and by 1979 US inflation was beginning to spiral out of control. As the Federal Reserve struggled with the problem of monetary control, regulators were very aware that non-bank liabilities and the Eurodollar market with its 20% per annum growth rate were part of the problem (Hawley 1984: 148). As the nature of the money supply was transformed, the Fed began to have control over only a portion of the de facto money supply: the Fed had traction over local domestic markets, but not the Eurodollar market; it had traction over bank-reliant SMEs, but not large firms that could raise funds on the commercial paper market (which was of course also bank-reliant, but off-balance-sheet and subject to little or no monetary control). The changing nature of the money supply meant that by the end of the 1970s the tools of monetary policy mostly affected local domestic markets and SMEs, that is those with no or limited access to Eurocurrency and commercial paper markets (Hawley 1984: 149, 153).

As a result, in early 1979 Fed Chairman Miller, New York Fed President Paul Volcker, and Treasury Undersecretary Anthony Solomon (who would succeed Volcker as New York Fed President) sought (i) to bring non-banks within the purview of the Fed’s control and (ii) to control and regulate the Eurodollar market (Hawley 1984: 151).[1] The Depository Institutions Deregulation and Monetary Control Act of 1980, which is discussed in a previous post, was (mistakenly) expected to address the first agenda item.[2] The second item required coordination with foreign regulators. This type of coordination had been initiated in 1974 with the formation of the Basel Committee of Bank Supervisors (“BCBS”). The US policymakers in 1979 had two policy objectives: the systematic collection of data on Eurocurrency markets and the imposition of minimum reserve requirements on Eurocurrency deposits (Hawley 1984: 152-55). The BCBS was, however, composed of regulators with very different interests and thus was unable to frame a common approach to the problem, much less a common solution. Neither of the regulators’ goals was achieved (Kapstein 1994: 52; Hawley 1984: 158-59). Acknowledging defeat, US regulators ultimately stopped advocating for controls on the Eurodollar market and settled instead in 1981 for a policy that attempted to draw the offshore accounts onshore by permitting international banking facilities (IBFs) – with their minimal level of regulation – to be located in the United States (Hawley 1984: 156; 46 FR 32426). This was a solution the biggest banks had been lobbying for since 1978 as a step towards deregulation of the domestic market (FRBNY 1978).

The bank regulators imposed the first mandatory capital requirements on banks between 1980 and 1981 without Congressional prompting, presumably due to concern over the deterioration of bank balance sheets during Volcker’s interest rate hike (FDIC 1997b: 89. Prior to this policy, regulators were described as “attempting to persuade” banks to improve their capital ratios, Gilbert et al. 1985: 15.)[3] Notably the distinction between primary (now called Tier I) and secondary (now called Tier II) capital, that is the treatment of subordinated debt of more than seven years as secondary capital, was incorporated into these early requirements.[4]

By mid-summer 1979 there was a sense that the economic situation was spiraling out of control and that President Carter might not have what it takes to deal with the situation (Greider 1987). Carter reconfigured his cabinet and, after moving the Chairman of the Federal Reserve to Treasury, appointed Paul Volcker to the Federal Reserve. There is no question that Volcker’s job was to restore economic confidence – or that Volcker was going to take aggressive measures to stem the rise in prices. Note that Volcker was aware that one of the reasons interest rates would have to be raised to unprecedented levels was because the Fed’s monetary control had been eroded by the growth of thrift transaction accounts, money market funds, and Eurodollars (Volcker 1979: 54-56).[5] This also meant that when monetary policy was used to slow the economy, local domestic markets and SMEs bore the brunt of the burden, while firms with access to international markets bore less of it. Volcker viewed the oil price hike as a stimulus to inflation that was forcing him “to push harder against inflation than ever before and risk damage to economic activity here and abroad” (Volcker 1980: 33).

In order to force inflation back under control, Volcker initiated a policy of raising short-term interest rates as high as was necessary to complete the task.[6] Early 1980 was a moment in Fed history when the path set by the Fed was designed to shift the future performance of the economy onto a better path. As a result, the last thing the Fed needed was to set off a banking collapse. And Paul Volcker knew that the Fed had the capacity to keep a troubled bank alive indefinitely. Thus, a little recognized aspect of Volcker’s monetary policy was a commitment to support banks through the tight money period – in order to ensure that the seeds of confidence that Volcker was sowing could take root.

Just eight months into Volcker’s chairmanship, the sharp rise in interest rates triggered the failure of an incompetently managed bank.[7] (This discussion is based on Sprague 1986: Ch 5.) In 1968 First Pennsylvania Bank, one of the nation’s oldest banks, had appointed a CEO who sought to join the ranks of the largest banks by embracing a policy of aggressive growth based on volatile funding sources such as brokered certificates of deposits and Eurodollars, together with not-so-careful loan origination. Increasingly intrusive Fed supervision starting in 1969, had led the bank to convert in 1974 to a national charter and OCC supervision. Finally, in 1976 the bank had tried to gamble its way out of its difficulties by investing heavily in long-term Treasuries that were paying unprecedentedly high yields, funding the purchases with short-term borrowings.

By the start of 1980 the OCC, whose Comptroller was a member of the three-man FDIC board, was sure that when First Pennsylvania reported another quarter of massive losses, a run on its market-based funding would ensue. The FDIC had spent the previous year preparing for the failures of mutual savings banks that were doomed in the contemporary high interest rate environment through no fault of their own. Thus, the remaining two FDIC directors were acculturated to imposing market discipline on banks, and had to be convinced that there was a good reason to make an exception for First Pennsylvania. Their resistance was worn down in no small part because the Fed was lending ever increasing amounts to the bank and Fed Chairman Paul Volcker told the FDIC board that he was committed to continue doing so. At the same time, the Fed alongside the Comptroller (and FDIC Board member) pressured the remaining two members of the FDIC board that “there was no alternative” to an FDIC bailout as a crisis of confidence would follow. The FDIC, of course, knew that the Fed could keep the bank alive indefinitely – at increasing cost to the insurance fund as more and more uninsured depositors withdrew their funds.

The FDIC finally settled on a bailout via a below market-rate loan together with warrants that would provide a controlling interest in the bank. In this case, the bailout was successful: within five years First Pennsylvania had paid off the FDIC loan and bought back the warrants.[8]

Observe what had taken place. In market-based lending’s first decade, it had been used to hold financial regulators hostage, not once, but twice. At least in response to the Franklin National failure the Fed Board had recognized that the bailout was a very dubious way to socialize private losses and therefore sought to dramatically expand control over the banks. The First Pennsylvania bailout, although it took place only six years later, did not generate a similar reaction. Bailouts of poorly managed banks – at least those that were financed on the Eurodollar market – had become the usual course of business for the Fed.

One can only speculate as to what had happened within the culture at the Fed that made possible this shift in policy in favor of bailouts. Two factors, however, stand out. It seems very likely that the turnover that was taking place at both the Fed Board and the Fed’s General Counsel’s office played a role in the normalization of the use of the Fed to socialize private losses. And it is noteworthy that banks were using the language of the new portfolio theory to frame their activities: in federal testimony they presented the “competitive advantages” provided by Eurodollar markets as promoting “efficient” allocation of resources; they described the Eurodollar market as “simply an efficient intermediary between national markets,” denying the evident capacity of the Eurodollar markets to create money; they portrayed the offshore interbank market as something that should be ignored when calculating monetary aggregates – despite the fact that Eurodollar markets were funding banks that could not get domestic funding; at the same time they argued that the central banks as lenders of last resort were “responsible not only for the banking systems, but … for the totality of financial markets” (Weatherstone 1979a, 1979b; Ogden 1979).[9] In this environment where the instability being generated by Eurodollars and other forms of so-called market-based funding was not being acknowledged as a problem, the coming bailout of Continental Illinois National Bank had been made inevitable.

LINKS
Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois
Implications

[1] Eventually Governor Wallich got on board, worried that Fed could lose control of monetary aggregates (Hawley 1984: 153).

[2] DIDMCA made the thrifts subject to the Federal Reserve’s reserve requirements, eliminated Regulation Q interest rates caps, and increased the level of deposit insurance in hopes of giving deposits a competitive advantage over money market funds. As was noted in a previous post, regulators at this time apparently underestimated the importance of structural separation and simply assumed that deposit insurance was the key stabilizing innovation of the 1930s.

[3] The International Lending Supervision Act of 1983 also mandated the imposition of capital regulations (Pub. L. 98-181 §908; FDIC 1997b). Wallich (1981) indicates that the early capital requirements that were being implemented by examiners were still not very effective and served mostly to put a bank’s management and board on notice that a problem was brewing.

[4] The treatment of subordinated debt as capital dates backed to Kennedy’s enterprising Comptroller of the Currency, James Saxon, who was the first regulator to approve the issue of subordinated debt by banks. At the same time he ordered its treatment as capital (Mayer 1974: 397-400). By 1970 all the federal regulators permitted the issue of subordinated debt (Mayer 1974: 237). On Saxon, see also Kettering 2008: 1667.

[5] Note also that Volcker had a more sanguine view of the severity of the effects of Eurodollars and nonbanks on monetary control than, for example, Anthony Solomon, but also deferred to Treasury on international monetary matters (Volcker 1979: 33).

[6] Technically, there was a “monetarist experiment” first, but it is still being debated whether this was only a front to make Volcker’s aggressive policy more palatable (see e.g. Stigum & Crescenzi 2008: 377).

[7] The FDIC was able to force out the CEO, but not to undo the “golden parachute” he had negotiated prior to the collapse.

[8] In 1998 First Pennsylvania merged into First Union National Bank, which later changed its name to Wachovia. Wachovia failed in 2008 and was taken over by Wells Fargo.

[9] Hawley (1984: 132-34) describes the contradictory positions taken by the money center banks with respect to the Federal Reserve and the banking system as “policy schizophrenia.”

Dismantling the economy’s legal infrastructure V-5-b: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 2: The growth of LDC loans

The Growth of LDC Loans

Starting in late 1973 the Eurodollar market saw a significant inflow of funds as the first oil price crisis directed an extraordinary flow of funds to the OPEC member states, and they turned to the Eurodollar market as a safe savings vehicle that paid relatively high interest rates. As a result, funding costs plummeted for the large banks active in these markets. At the same time, these banks were losing their biggest commercial borrowers to the commercial paper market, supported with off-balance sheet guarantees from the money center banks. These banks had no desire to restrain the growth of their off-balance-sheet activities which both faced limited regulatory oversight and were protected from the competition of smaller banks. (Smaller banks couldn’t issuer off-balance-sheet guarantees as easily as large banks, because even in the 1970s a large bank failure was far less likely to impose losses on unsecured creditors since regulators always did their utmost to sell off a large, failed bank together with its liabilities, whereas small bank creditors were often handled more harshly.) Thus, the money center banks, faced with an unexpected windfall in funding and having shifted their traditional clients to off-balance-sheet financing, needed to find earning assets that were alternatives to their traditional commercial lending (FDIC 1997b: 196-98).

They turned to syndicated loans: in the late 1970s and early 1980s these loans typically financed the dollar-denominated debt of developing countries.[1] After the LDC debt crisis of the early 1980s, syndicated “leveraged loans” would be used by the banks in partnership with takeover specialists to load conservatively run companies with debt. At the same time, mortgage lending was opened up to banks and this would become another avenue for non-traditional on-balance-sheet lending.

Despite the common claim that in the 1970s the banks were “recycling” petrodollars from oil exporting countries to oil importing countries, that was more the job of the multilateral institutions, such as the IMF, which was willing to lend to countries with significant credit risk. Although the Eurocurrency markets tripled in size from 1973 to 1978, less than 30% of the $325 billion increase was accounted for by the OPEC surpluses (Volcker 1980: 9, 15).[2]

Furthermore, the banks were lending to a select group of developing countries, some of which were oil exporters (Spiro 1999: 70-71). This is explained by the support provided by the developed countries to their export industries in response to the oil crisis. By increasing the provision of government guarantees on the debt incurred by the buyers of the exports many developed countries were able to keep their current accounts from going heavily into deficit (Kapstein 1994: 62, 68).[3] As a result, the deficits created by the transfer of value to the largest oil exporters were shifted towards developing countries. Indeed, by 1978 the OECD country current account surplus was greater than the OPEC surplus (Volcker 1980: 34). As the goods exports of developed countries increased in response to the export guarantees that were expanded during the oil crisis, even those developing countries that were oil exporters experienced deficits. Since the countries with a robust source of export earnings were naturally viewed as particularly creditworthy by the banks, these countries had generous access to the syndicated loans provided by the banks that operated in the Eurodollar market. Thus, Spiro (1999: 130-31) questions the standard narrative which assumes that finance does not have a causal role in driving trade flows and asks instead whether it was the banks’ willingness to fund a developing country’s debt that made it possible for that country to run a trade deficit.[4]

By 1976 divisions were showing amongst the developing countries. In May at a UN Trade and Development conference the G-77 countries were seeking a moratorium on debt. They did not, however, have the support of the biggest and richest developing countries, which were the beneficiaries of the money center banks’ syndicated loans and as a consequence had the most to lose from being shut out of international lending markets (Kershaw 2018: 303) – or so they thought at the time. In fact, over the course of 1976 US banks would seek to reduce their exposure to Mexican debt in the face of a growing expectation that currency devaluation would be necessary in order to address the current account deficit. Needless to say, such prophecies are self-fulfilling. As market-based credit became scarce, Mexico was forced to turn to the IMF which imposed currency devaluation as a condition of its loan (Kershaw 2018). In the months before the IMF loan was concluded, the Federal Reserve provided a $360 million credit line to Mexico and then repeatedly rolled it over in order to avoid a moratorium on the Mexican debt and the consequent damage to the US commercial banking system (Kershaw 2018: 307). Overall, at the behest of the IMF and the US government in 1976 the Mexican government chose to embrace austerity in order to maintain access to international credit markets.[5]

How then should the government role in the banks’ lending to developing countries be characterized during these early years of the LDC lending boom? For this early period, I have been unable to find clear evidence that “the U.S. government encouraged the American banks to recycle petrodollars to borrowers in Latin America” as Feldstein (1991) claims. In particular, there is little evidence that government officials attempted to direct the flow of funds to particular borrowers (Madrid 1990: 44). On the other hand, government officials created an environment where syndicated lending – and the LDC lending associated with it – was facilitated (Braun et al. 2019). First and foremost, as was discussed in detail in the previous post, US policymakers prevented a significant collapse in the Eurodollar market when they bailed out international creditors from the fraud perpetrated by Franklin National Bank. This was strongly reinforced by the September 1974 declaration of the G-10 central bankers that they were ready to support Eurodollar markets (see Kapstein 1994: 66 and Kershaw 2018: 305). When combined with the US refusal to support an expanded role for multilateral institutions to address the balance of payments problem, the effect was to place the burden of managing the balance of payments problem on the banks and the Eurodollar market (Spiro 1999: 141-43; Kershaw 2018: 305).[6] Add when one then adds to this situation the Federal Reserve’s role in the 1976 Mexican debt crisis,[7] one can easily conclude that LDC lending was the natural consequence of the environment created by US policymakers during the oil crisis when they demonstrated in 1974 and 1976 that they viewed instability in the international monetary system as a threat to US hegemony and were therefore willing to take unprecedented actions to avoid such instability by bailing out the money center banks, both directly and indirectly and with no exception for cases of fraud. It is equally unsurprising that in this environment the LDC loans were high margin and very profitable during the boom years of the 1970s (Madrid 1990: 46 -52).

While one can take the position that the Franklin National bailout and the role played by the Fed in the 1976 Mexican debt crisis served to “encourage” US banks to lend to developing countries, it is worth pausing a moment to consider what this approach implies. The Federal Reserve had demonstrated (i) that it was committed to protecting the Eurodollar market creditors from the failure of a US bank and (ii) that together with Treasury it was willing to intervene in a case of sovereign default to protect the interests of US banks. To the degree that these actions are treated as “encouragement” to the banks to increase their loans to risky sovereign borrowers, the mechanism at work is clearly moral hazard, or the tendency of insurance to cause an increase in risk-taking. In short, when people like Martin Feldstein claim that the US government encouraged LDC lending by banks in the early years of the lending boom, what they are actually acknowledging is that the Federal Reserve’s protection of interbank markets was creating a serious moral hazard problem and driving a significant increase in bank LDC lending.

To the degree that such “encouragement” existed, it was not at all uniform. By 1977, the Federal Reserve was expressing concern that the syndicated loans to developing countries would cause problems for the banks (FDIC 1997b: 198-99).[8] The regulators gathered data so that they could track bank lending to LDCs carefully and so that the banks had appropriate data with which to refine their underwriting techniques (Volcker 1980: 13). On the other hand, in keeping with its history of lax regulation the OCC issued a Final Rule in 1979 that had the effect of increasing the exposure that a bank was permitted to have to any single country.[9] Overall, regulatory demands that banks control their foreign lending were moderately successful in 1977, restricting the growth of LDC loans to 11% (Burns 1977b; Madrid 1990: 59).[10] But by 1978 US bank loans to developing countries were growing by 17% per annum, a rate that more or less continued until the 1982 debt crisis (Madrid 1990: 59).

In the meanwhile, in response to the unprecedented role played by the Federal Reserve in the bailout of Franklin National Bank, the Fed was seeking a significant expansion of the regulators’ statutory authority over both bank holding companies and bank management. The legislative reforms demanded by the Fed included (i) authority to regulate foreign banks operating in the US, (ii) establishment of a Council to set uniform bank regulations in the US, (iii) monetary penalties for violations of banking laws and regulations, (iv) authority for the Fed to compel divestiture of a nonbank from a bank holding company if it poses a serious financial risk to a subsidiary bank, and (v) an expansion of the grounds for removal of bank officers and directors to include continuing disregard for safety and soundness (Burns 1977a).

This legislative wish list was largely granted in the Financial Institutions Regulatory and Interest Rates Control Act of 1978 (“FIRA” Pub. L. 95-630).[11] By the time FIRA was passed, however, Thomas O’Connell, the long-time Fed attorney, who likely shaped the law’s provisions, was just two months away from his death, Arthur Burns’ term as Fed Chairman had expired, and President Carter had appointed a new Chairman. Furthermore, this was an era of particularly rapid turnover not just of attorneys in the General Counsel’s Office, but also of Federal Reserve Governors. As a result, by 1978 there was only one Fed Governor and not one General Counsel attorney who had been in office through the events of 1974.[12] Thus, it appears that due to the lack of continuity in the leadership of the Fed, several aspects of this substantial expansion of its statutory powers were never actually put to use.

Note: Many thanks to Benjamin Braun for helping guide me through some of this literature.

LINKS
Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois
Implications

[1] LDC lending by commercial banks rose by $120 billion from 1973 through 1979 (Volcker 1980: 10-11).

[2] One should also note that on the bank funding side of this equation, a significant portion of the OPEC surplus was processed through the domestic US and European banking systems. Only about one-third of the “petrodollar” funds flowed through the offshore Eurodollar markets (Spiro 1999: 58; Kapstein 1994: 67).

[3] Note that Kapstein’s source for this is Wellons (1987).

[4] The facts that the non-oil LDCs import prices rose faster than their export prices and that their export trade with developed countries grew slowly (Volcker 1980: 18) may support Spiro’s claim.

[5] Because, as was acknowledged at the time, Mexican exports had little room to grow and were already effectively priced in US dollars, the devaluation was not likely to increase the revenue from exports, but instead would have to work by reducing Mexican consumers’ demand for imports (Kershaw 2018: 307).

[6] In addition, the relaxation of capital controls in the US made it possible for the petrodollars that flowed into the domestic US banking system to flow out again (Kapstein 1994: 68).

[7] The role of the Fed and the Treasury in the 1976 Mexican debt crisis likely explains Madrid (1990: 70-72)’s finding that bankers expected official intervention in the event of a sovereign default.

[8] Fed Chairman Arthur Burns (1977b) offered a particularly astute evaluation of the risks to the global economy as it was adjusting to the oil price hike (together with an unrealistic assessment of the benefits of IMF loan conditions to developing countries). Because he understood that many countries were being forced to borrow heavily and that banks were likely to “be tempted to extend credit more generously than is prudent,” he saw significant risks to the international credit structure, especially in the event of another large recession or “a new round of oil price increases.” In the absence of such challenges, he was optimistic that an increase in official lending, better data collection on developing country credit risk, and the benefits of IMF conditionality – supporting not just the repayment of IMF but also private sector debt – would together result in a successful adjustment of the world economy. He encouraged private lenders to avoid undercutting the IMF and more particularly to coordinate with the IMF in demanding loan concessions. He also called out oil-importing countries that were running persistent surpluses for the costs they were imposing on the rest of the world. (A refrain that has been resonating for nearly a century now.)

[9] There was a statutory limit on loans to any single “person” to 10% of capital, and regulators had traditionally treated all foreign loans to any government entity as loans to that country’s “government” as a single person for the purposes of the statute (Kapstein 1994: 77). In the Final Rule depending on how the loan was to be used and on the means of payment available to the borrower, this aggregation would not be required (44 FR 22712, 1979). Paul Volcker, President of the New York Fed at the time, apparently took a positive view of this regulatory change describing it as “a Solomon-like judgment” (Kapstein 1994: 77).

[10] Note, however, that in this year non-US banks apparently stepped into the breach, so total LDC debt to private creditors increased by 33% (compare Kapstein 1994: 71 to Madrid 1990: 59).

[11] The authority to force a BHC to divest a subsidiary is encoded in 12 USC s. 1844(e), the authority to force termination of an officer or director is encoded in 12 USC s. 1818 (e), and the Federal Financial Institutions Examination Council was formed in 12 USC 3301.

[12] Henry Wallich was the Governor. Philip Coldwell had arrived at the Board late in October 1974. Two attorneys in the General Counsel’s office had been hired over the course of 1974, Charles McNeil and Allen Raiken.

Dismantling the economy’s legal infrastructure V-5-a: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 1: Eurodollar markets

In 1971 Nixon put an end to the Bretton Woods agreement by unilaterally terminating the US commitment to exchange dollars into gold. It was no coincidence that at about the same time US regulators began to ignore Walter Bagehot’s most basic advice: under no circumstances should a government give aid to a bad bank.[1] It was the desire to promote international financial stability and to protect the role of the dollar in the world economy that made it possible for a consensus in favor of bank bailouts to develop.

For fifteen years after the collapse of Bretton Woods the fundamental stability of the international financial system was being challenged every few years. The US supported financial stability by effectively guaranteeing that the creditors of a large international US bank would be protected whether or not the bank had engaged in fraud and was as a result insolvent. I argue here that the means by which the international financial system was stabilized involved a catastrophic mistake that has yet to be rectified. The foundations of the previous international order had been constructed on a tight-knit London money market where there was no question that one bank’s fraud was every bankers’ problem and prompt reporting of concerns about not just fraud, but even insufficient controls, at counterparty banks was both expected and understood as a moral imperative. The new international order left responsibility for both stopping fraud and ensuring that a high level of internal controls was being maintained entirely in the hands of US regulators who were in no way equipped for the task. These regulators ended up developing an ideology that imagined that both fraud and mismanagement would have the “natural” effect of extinguishing themselves. So here we are.

The development of the Eurodollar market in the early 1970s

The collapse of Bretton Woods is closely associated with the growth of both international banking and the Eurodollar market, that is, the market for dollar denominated bank accounts held in banks outside the United States. This growth took place in part because capital controls were lifted, but also because of the Federal Reserve’s commitment to support the market by standing ready to protect the offshore creditors of US banks that failed.[2] To understand why the Eurodollar market exists, we must look back to the early years of the Bretton Woods agreement.

In the years following the end of the Second World War, restrictions on the use of sterling in international trade led to a shift in favor of the dollar as the currency in which short-term trade credit was denominated (Strange 1976: 60). Since it was British banks that had expertise in the finance of international trade, the result was the birth of the Eurodollar market and dollar denominated accounts held in London. Because these accounts must clear through the US banking system, they are held either as deposits in foreign branches of US banks or in foreign banks that have access to the US clearing system through a US correspondent bank. US regulators chose to exercise little control over the Eurodollar market and thus allowed it to grow, relatively unregulated, until by 1973 it was $132 billion and equivalent to about 20% of US commercial bank deposits (Kapstein 1994: 35; St. Louis Federal Reserve Fred database). By 1980 it was $575 billion and a little less than half the amount of US commercial bank deposits (Kapstein 1994: 21).

In 1973 the US money center banks did not have the experience that British banks had in financing international trade. As a result, the US connection to international markets was managed through the Eurodollar market and relied heavily on the London interbank and foreign currency markets. When the Eurodollar market was disrupted, the whole of dollar-based international trade was threatened, because the US was not prepared to provide equivalent services in New York or any other domestic financial center. As a result, instability in the Eurodollar market threatened global trade and also, according to pessimists, a complete breakdown of the international financial order akin to the Depression (Spero 1980: 115). In the 1970s subsequent to the termination of the Bretton Woods agreement, US policymakers faced the challenge of proving to the world that they were competent to manage the new international financial order – and the first order of business was protecting the stability of the Eurodollar market.

While the first bailout of a large bank, the Bank of the Commonwealth, was mostly a domestic event,[3] it was triggered by the Federal Reserve’s decision not to let the bank in question open a foreign branch that would have given it access to Eurodollar funding.  (The following account derives from Sprague 1986: Ch 4.) Such decisions are public and in this case the decision was delivered with a very clear statement about the Fed’s concerns about the bank’s management and general condition.

Through the 1960s an enterprising bank lawyer at the Bank of the Commonwealth in Detroit had come up with a way to circumvent Michigan’s prohibition on bank holding companies and restrictions on bank branching: owning multiple banks through more than 100 interlocking partnerships run by just 18 general partners. The group’s activities were financed by Chase Manhattan Bank. The group’s management determined that in the high interest rate environment of the late 1960s punting on municipal bonds was a sure-fire way to make capital gains when interest rates fell. (Of course, they didn’t fall.) Management also deliberately created future tax deductions – and booked their value upfront as income. Regulators spent years trying and failing to “nudge” this network of banks into less disastrous behavior. Finally, in 1970 the Fed pulled the plug and forced the group to start selling off their banks. Chase Manhattan ended up taking over the biggest bank in the group, the Bank of the Commonwealth, but due to interstate banking restrictions could only own the bank for two years.

Under any rational system this would have been Chase’s problem to solve. But the Fed was concerned that the failure of a billion dollar bank could set off a banking crisis and so in 1972 the Fed put pressure on the FDIC to bail the bank out. The challenges of managing the dollar in the new environment with no tie to gold undoubtedly affected the Fed’s views. Under this pressure, the FDIC caved and provided its first bailout of any significance. According to Irvine Sprague, the FDIC chairman at the time, his eventual justification for the bailout was to avoid an increase in the significant concentration in the Detroit market – from 77% to 87% of deposits in just three banks – that would be created by a takeover of the Bank of the Commonwealth that complied with Michigan’s legal restrictions on branch banking. This explanation reads, however, like the veneer of conscience-soothing justification that any one of us is apt to adopt when forced to take a decision that is patently unjust.

While the FDIC was careful to structure the bailout as a loan and to force the Bank of the Commonwealth to book a loss on its investment portfolio, the loan paid a below market rate and the FDIC was forced to extend the loan multiple times, so that payment was not complete until 1995. From a banking theory perspective the extension of a loan that will be repeatedly rolled over is effectively an equity investment. Thus, the effect of this first bailout of a large bank was that the FDIC put de facto equity into a bad bank. Unsurprisingly the FDIC board had little desire to repeat this experiment. The spread of international banking would, however, affect the FDIC’s decision-making process.

*****

The structure of the US regulatory system rendered extremely difficult the task of demonstrating to the world the competence of the United States in managing the new international monetary system. There were three federal bank regulators in the United States. Banks with a national charter were regulated by the Office of the Comptroller of the Currency (“OCC”), while state-chartered banks were regulated both by state banking authorities and either the Federal Reserve or the FDIC depending on whether the bank was a Federal Reserve member bank.[4] The OCC was (and is) funded by the assessment it imposes on national banks, and had a long history of attracting banks by offering more favorable regulation. In this era, the OCC was also notoriously uncooperative with its fellow regulators (Sprague 1986: 236).

While US banks were accustomed to navigating the regulatory turf battle and apparently knew when to be cautious about taking on exposure to an instrument approved by the OCC, but not the Fed or FDIC, foreign banks did not have this skill. With the massive growth of cross-border banking this had the natural effect of leaving foreign banks exposed to an instrument that the Fed and FDIC considered ultra vires, that is, beyond the limits of the activities permitted to a bank. Because national banks had been issuing these instruments – standby letters of credit – for a decade before the FDIC had the opportunity to challenge their validity in court in First Empire Bank v. FDIC,[5] foreign banks were “infuriated and embarrassed” when the FDIC did not immediately honor them (Spero 1980: 94).

This case arose in 1973, a year which opened with the de facto floating of exchange rates after the failure of efforts to peg rates subsequent to the collapse of Bretton Woods, and closed with the Iranian revolution and the first oil crisis. In short, 1973 was a year in which the bezzle[6] generated by a decade of lax financial conditions in the US was beginning to be revealed as fraudulent banks were exposed. The FDIC case associated with these arguably ultra vires instruments arose when the bank that issued them failed and was purchased, and the buyer refused to assume the standby letters of credit due to an underlying fraud. As a result, the instruments were transferred along with other bad assets to the FDIC. Ultimately, the FDIC in its lawsuit over the standby LOCs didn’t even raise its strongest legal argument, i.e. that the instruments were ultra vires, a fact that the adjudicating court commented on (Kettering 2008: 1669). It seems likely that the FDIC backed down in no small part, because having an apparently well-established instrument declared ultra vires would have threatened global confidence in the competence of the United States as a manager of the international financial system at a time when that system was already under a great deal of stress. It was by this far from carefully considered process that bank issuance of standby letters of credit became a generally accepted activity in the US.

*****

The next bank to have its fraud exposed had been speculating on currencies and then covering up its losses (amongst other misdeeds). Franklin National had grown very quickly to become the 20th largest US bank, and in 1973 the size – and unprofitability – of the positions it was taking in the foreign exchange market made its lack of internal controls obvious to its counterparties who had shut it out of the market for forward contracts (Spero 1980: 83-84). By the end of 1973 Franklin had to pay a premium for the Eurodollar borrowings on which it relied heavily – and Spero (1980: 93) connects this premium to the FDIC’s treatment of the putatively ultra vires standby letters of credit discussed above which raised concerns in foreign markets about exposure to the failure of a US bank.

In May 1974 when Franklin finally lost access to Eurodollar funding, the Federal Reserve decided that it was in the interests of financial stability to support the bank. The Fed’s lending policies in support of Franklin National would shatter precedents as the $4.7 billion bank saw $2 billion in funding flow out over the course of two months (Spero 1980: 126-27).

This outflow was undoubtedly aggravated by the June 26, 1974 closure of a German bank, Bankhaus I.D. Herstatt of Cologne, also due to losses on currency speculation.[7] (This section relies on Spero 1980 and Kapstein 1994.) In this case, not only did the German Bundesbank choose not to support the bank, but the bank was closed while both the London and New York markets were open – and while a significant intraday balance was outstanding in both the foreign currency spot market and the interbank market. That is, the failure disrupted the settlement process in both markets causing losses and frozen funds. As the London interbank and foreign currency markets froze up, small and medium-sized banks were either shut out of them or forced to pay a premium. Only in September 1974, after the G-10 central bankers issued a joint statement that “the means are available … for the provision of temporary liquidity” to the Eurodollar market, did interest rates on the market fall (Schenk 2014: 1141).[8] The tiered rate structure in interbank markets would continue into early 1975. In many cases, small banks were unable to execute foreign currency trades for their clients. To revive the foreign exchange spot market the New York Clearinghouse created a temporary emergency rule allowing banks to recall payments one day after they were made. It would remain in place for almost six months. As Herstatt’s foreign exchange trading book was only one-tenth the size of Franklin National’s, there was good reason to believe that a disorderly failure of Franklin could have had a devastating effect on the nascent Eurodollar markets and would have – at a minimum – created major complications for the program of establishing a post-Bretton Woods international monetary system (Spero 1980: 113-14).[9]

Before Franklin National was finally sold in October 1974, the Federal Reserve had lent it almost $1.8 billion allowing unlimited outflows to foreign branches abroad that would ultimately amount to nearly half a billion dollars. As Franklin National ran out of collateral in the US, the Federal Reserve arranged for the Bank of England to act as the Federal Reserve’s agent maintaining physical possession of collateral in London.[10] The loan to Franklin National was of such long duration that the Fed altered its regulations in order to charge an interest rate above the official discount rate – and closer to the market rate – in cases of “protracted assistance where there are exceptional circumstances or practices involving only a particular member bank” (Spero 1980: 204n19).[11] Finally, because Franklin was shut out of participation in the London foreign exchange market due to settlement risk, and no buyer was willing to take on Franklin’s foreign exchange book due to its reputation for unauthorized and illegal trading, the Federal Reserve Bank of New York had to purchase the trading book and operate it until all the outstanding contracts were filled (Spero 1980: 132-35).[12]

Finally, on October 8, 1974 the bank now just $3.7 billion in size was declared insolvent, after the Fed and FDIC had managed to arrange a government-assisted sale of the bank. Franklin’s deposits were assumed by the purchaser which was permitted to select $1.5 billion in assets to form a “good” bank. The remaining “bad” bank assets along with the loan from the Federal Reserve were transferred to the FDIC for liquidation. The liquidation was complex and involved substantial litigation. Ultimately, in 1989 the FDIC returned $23 million to the shareholders of Franklin National (FDIC 1997a: 262).

It is easy to underestimate the enormity of the decision to take such extraordinary action to ensure that Franklin National’s creditors were made whole. The Federal Reserve because of its vast holdings of US government debt remits its surplus profits to the US Treasury every year – and the FDIC which was also put at risk by this policy has access to a line of credit from the Treasury. The Fed effectively committed the full faith and credit of the US government to stand behind the liabilities of US banks with significant exposure on the Eurodollar markets – whether or not they were engaged in fraud (which Franklin National most definitely was). There is no question that this provided significant support to the dollar’s role in international finance subsequent to the collapse of Bretton Woods – which was both the intent of the policy and a rather obvious effect of it. The policy is, however, euphemistically referred to in the literature as that of a “lender of last resort” or provision of liquidity to international markets (e.g. Kapstein 1994: 20, 42. See also Gourinchas, Rey & Sauzet 2019). Of course, since it is in practice a credit guarantee – which is why the FDIC is involved – it really has nothing to do with liquidity at all. The likely reason this is referred as “liquidity” support is that the Federal Reserve does not have legal authority to provide a credit guarantee to a bank. I will discuss below how this fairly direct government support of the US money center banks represented a complete transformation of the nature of the international monetary system. For now, however, let us continue with our history.

GC tenure

Personnel changes in the Fed Board’s General Counsel’s office may help explain the extraordinary nature of the Fed’s support of Franklin National: just when the bailout took place the average level of experience as staff in the Federal Reserve General Counsel’s Office of the attorneys in the Office fell below two years, down from 8 years in 1969.[13] In short, the attorneys making these decisions had probably barely begun to understand the basic operations of the Fed, much less the most appropriate way to handle a crisis. The reasons for this are unclear. Was this the beginning of the “revolving door” where banks offered huge paychecks to Fed lawyers that were not matched by the salaries paid by the Federal Reserve? Was General Counsel Thomas O’Connell a catastrophically bad manager, or was he the only attorney with such a strong sense of public service that he stayed at the Fed despite strong financial incentives to leave? Was the exodus of attorneys somehow associated with the new role of the Fed created by inflation and Nixon’s decision to end Bretton Woods? We do not know.

One of the most remarkable events of 1974 that took place within the Fed was the Board’s appointment of Thomas O’Connell, the only attorney with significant experience in the General Counsel’s office to a new position, Counsel to the Chairman. This took place on July 10 after it was clear that Franklin National was insolvent and that any sale of the bank would require government assistance (Spero 1980: 137). At the same time, Andrew Oehmann was made Acting General Counsel (Fed Bulletin July 1974). Oehmann, who had served in the Kennedy Administration but had little banking experience, had been hired in 1973 as Special Assistant to the General Counsel. At the time the only attorney remaining in the General Counsel’s office who had been hired before 1972 was Pauline Heller, and she had been brought in as a specialist in bank holding companies in 1969. A very high level of staff turnover continued through the 1970s. As a consequence, the only Fed attorney with long experience in the General Counsel’s office continued to be Thomas O’Connell who would serve not as General Counsel, but as Counsel to the Chairman until his death in January 1979 at 53 years of age.

The decision to move O’Connell out of the General Counsel’s office and into a position advising the Chairman is remarkable, especially when one takes the timing of the decision into account. As General Counsel to the Board of Governors, an attorney must treat the Board itself as its client and may not advise the Chairman as an individual, except to the degree that the Chairman’s interests are closely aligned with those of the Board. In particular, if the Chairman were to insist on acting in a manner that was clearly illegal the Board’s attorney would have a duty to report the Chairman to the Board and/or the White House. On the other hand, the Counsel to the Chairman does not need to put the Board’s interests first, but can advise the Chairman as to how best to achieve his goals – and for the most part it would be unethical for an attorney to report on his client based on confidential attorney client communications. In short, moving the General Counsel into the role of Counsel for the Chairman in the midst of an unprecedented bailout of financial markets gives the appearance that the Fed Board at this time was preparing to act in a way that did not just push to the limits of the Fed’s statutory authority but also exceeded them. In this situation, O’Connell could have chosen to resign, but that would have left the Fed Board without a single attorney with significant General Counsel experience. It is easy to imagine that an attorney placed in this situation might conclude that the interests of the public as well as the Fed would be better served if he did not resign. It is perhaps telling that O’Connell died of health problems at 53. In any event, the General Counsel’s office was left with no one with any depth of experience in the job though the Franklin National bailout, and this makes it somewhat less surprising that the Fed was setting new precedents in 1974 rather than following old ones.

The implications of the remarkable rescue of the Eurodollar market from the consequences of Franklin National’s failure were not ignored by the members of the Board. Two weeks after the assisted sale of the bank, Federal Reserve Chairman Arthur Burns gave a speech addressing the fact that “for the first time since the Great Depression, the availability of liquidity from the central bank has become … an essential ingredient in maintaining confidence in the commercial banking system.” First, he analyzed why this had taken place and then discussed what needed to be done to ensure “a free enterprise system.”

Burns described five destabilizing and interconnected trends that had been generated by the new policy of promoting competition in the banking sector: declining capital, increasing reliance on volatile market-based funding, expansion of off-balance-sheet commitments, declining asset quality, and for the largest banks increased exposure to foreign currency risk. He then explained that these trends had raised questions about bank solvency and found that “while faith in our banks is fully justified, it now rests unduly on the fact that troubled banks can turn to a governmental lender of last resort. … In a free enterprise system, the basic strength of the banking system should rest on the resources of individual banks.” After listing the ways in which the Fed was restraining the banking system, he concluded that it is time to set aside the tacit assumption that “the sweeping financial reforms of the 1930’s had laid the problem of soundness and stability to rest” and that “a substantial reorganization [of our bank regulatory system] will be required” to avoid the problem of “competition in laxity” and a complete failure to address the demands of this new environment.  He emphasized that it was important to end the system whereby banks were free to choose their regulator (Burns 1974). Burns’ colleagues on the Board of Governors expressed similar concerns, and one of them went so far as to conclude that if banking was going to be a “no failure industry”, then public “control” would probably be necessary (Coldwell 1976. See also Holland 1975). Reforms promoted by Burns were adopted into law in the Financial Institutions Regulatory Act of 1978.

LINKS
Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois
Implications

 

[1] “If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.” (Lombard St, Ch IV ¶ 4.)

[2] Some have argued that the deposit of “petrodollars” by oil-exporting countries also played a large role in the growth of the Eurodollar market, but that growth was in fact much faster than can be accounted for by OPEC countries (Spiro 1999: 60-62).

[3] Note, however, that the first FDIC bailout was of a tiny minority-owned bank in Boston that the FDIC sought to support in hopes of fostering banking services in a disadvantaged community (Sprague 1986). The experiment was not a success, and there have been virtually no bailouts of small banks since.

[4] The Federal Reserve had two forms of additional authority over banks. All national banks were required to be members of the Federal Reserve, and the Fed was the regulator of all bank holding companies, which typically were the owners of the national banks.

[5] First Empire Bank v. FDIC, 572 F.2d 1361 (9th Cir. 1978).

[6] Galbraith (1955): “At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars.”

[7] While employees of Herstatt were later convicted for hiding their losses using improper accounting entries, the criminal convictions associated with the Franklin National failure were much more extensive.

[8] The Federal Reserve’s stance on the Eurodollar market increased the attractiveness of depositing Eurodollars in US bank foreign branches, but caused some consternation amongst certain European central bankers who were unwilling to provide similar encouragement to offshore banking (Kapstein 1994: 42).

[9] As the OPEC oil exporting countries were important beneficiaries of the smooth operation of the international monetary system, the counterfactual of a collapse in that system raises the possibility that oil prices would have been forced down due to a collapse in trade – and thus that the world would have been sent down a very different historical path.

[10] In addition, to avoid publicity the Federal Reserve typically does not “perfect” its liens in the collateral it takes because doing so requires providing public notice of the lien. This practice leaves it open to third party claims on the collateral. In order to ensure that Franklin National’s London assets would actually be transferred into the US liquidation, the Bank of England arranged to transfer the collateral to the FDIC immediately upon the formal declaration of insolvency of the bank, effectively spiriting the collateral away from any of Franklin’s creditors in London who might have a claim to it (Spero 1980: 152).

[11] In the event, Franklin was only charged the special rate starting in late September, and thus only paid it for 11 days.

[12] The contract of sale for the foreign exchange book required Franklin to indemnify the New York Fed for any losses in excess of those estimated – and when Franklin was finally declared insolvent a month later the FDIC assumed the contract and therefore indemnified the New York Fed for any excess losses (Sper0 1980: 135).

[13] Through most of the 1960s the office had been staffed with a stable team of five to six attorneys, who had many dozens of years of Federal Reserve General Counsel experience between them and were led by General Counsel Howard Hackley who had been a law clerk in the office in the 1930s. When Hackley departed in 1968 things changed. The next General Counsel served only three years and by 1970 when Thomas O’Connell, who had joined the General Counsel’s office in 1956, took the helm, all the other experienced attorneys had left.

A brief history of the shadow banking collapse in 2007-08

A large number of “market-based” financing vehicles that developed in the years leading up the the 2007 crisis were designed to exploit the fact that some investors were only worried about AAA-ratings (or for commercial paper A1/P1-ratings) and didn’t bother to understand the products they were investing in. Several of these vehicles were literally designed to blow up — they had liquidation triggers that when breached in an adverse market could result in complete loss of the investment. Others were designed to draw down bank liquidity lines when the economic situation became more difficult. (The latter could only exist because of a reinterpretation of a 2004 final rule promulgated by the Joint Bank Regulators that had the effect of gutting the regulation. See here.) Others would expose investors in AAA rated assets to massive losses if mortgage default rates were significantly higher what was expected and/or exhibited more correlation than was expected.

None of these products was viable once investors and bank regulators had seen how they worked in practice. Thus, these products had a very short life and markets for them collapsed entirely in 2007-08. This post briefly reviews this history.

A. In 2007 the commercial paper segment of the shadow banking system collapsed.

The first commercial paper issuers to go were structured vehicles that didn’t have committed bank lines of liquidity support, but instead supported their commercial paper issues by contractual terms that could force liquidation in order to pay up on the commercial paper. Structured Investment Vehicles (SIVs) are examples. Shortly thereafter structured vehicles that did have bank lines of liquidity support, such as CDOs and MBS (only a small fraction of which were financed with commercial paper), drew down the bank liquidity lines with dramatic effects on the balance sheets of the banks involved. To protect the banks from catastrophe the Federal Reserve gave them special regulatory exemptions (see the Supervisory Letters to Citibank, Bank of America, and JP Morgan Chase dated August 20, 2007 and to other banks in subsequent months) and permitted banks to pledge at the discount window ABCP for which they provided back up lines of credit (WSJ Aug 27 2007). These exemptions together with the Term Auction Facility made it possible for the ABCP market to deflate slowly over the course of three years, rather than collapsing quickly and taking a few banks with it.

In short in 2007 the Federal Reserve let a variety of different shadow bank models collapse, while protecting the banks and stabilizing the money supply by keeping the ABCP market from collapsing too quickly. These decisions were classic lender of last resort decisions that had the effect of allowing some entities to fail and other to survive with central bank support. They are also fairly uncontroversial: just about everybody agrees that the Fed acted appropriately at this point in the crisis.

B. From 2007 to 2008 a huge number of structured finance vehicles went Boom

At the same time some of the more esoteric structured vehicles that issued longer term obligations but also relied on liquidation triggers to support their issues blew up. Examples of this category include Leveraged Super Senior CDOs and Constant Proportion Debt Obligations. In a leveraged super senior CDO investors pay, for example, $60 million to earn 1.5% per annum spread over safe assets by selling an insurance policy (that is, CDS protection) on the $750 million most senior tranche of a CDO. Because the investors are putting up so little money the LSS CDO has a liquidation trigger, so that if the insured tranche falls by, for example, 4% in value, the structured liquidates, and an alternate insurance policy is purchased on the market. The investors then get whatever is left after the insured party is protected. These structures all blew up in 2007.

The Constant Proportion Debt Obligation was an even crazier product. Instead of insuring only the senior most tranche of a CDO, it sold insurance on a high grade bond index, including 125 names. Because there were no subordinated tranches to protect it from losses, the insurance premium was higher. The CPDO was structured to take the excess insurance premium (i.e. that which was not paid out as a bond yield to the marks who “invested” in this AAA-rated product) and put it aside. If everything goes well in three years the CPDO can stop insuring debt and pay the promised yield by just investing in safe assets. Of course, if everything goes badly, liquidation triggers are hit and the investor loses. Guess what happened in 2007?

CDO squared and ABS CDO’s are similarly products that pay an investor a bond-like yield to take an equity-like risk. They, however, had tranches that were rated up to AAA by the rating agencies, and in some cases even the brokers selling the products appeared to believe that they were just another kind of bond. Cordell, Huang & Williams (2012) found that the AAA-rated ABS CDO bonds lost more than half their value. More specifically they found that median junior AAA-rated ABS CDO bond lost 100% of its value, and that senior AAA-rated ABS CDO bonds did better, but also lost more than half of their value. And virtually every bond rated below AAA lost all of its value (Table 12). Now that investors understand this product, they won’t touch it with a ten foot pole.

C. Private Label Mortgage Backed Securitization evaporates

Underlying the losses on ABS CDOs were losses on private label mortgage backed securities. 75% of ABS CDO issuance was in the years 2005-2007 and over these years 68-78% of the collateral in ABS CDOs was private label mortgage collateral
(again from the great paper by Cordell, Huang and Williams Figure 2).

Cordell, Huang and Williams also finds that the lower tranches of subprime MBS were apparently never sold in any significant numbers to investors. Instead they were placed into CDOs (p. 9). This inability to place the lower rated tranches as well as other structural problems with the treatment of investors may explain the complete collapse of the private label MBS market, which is documented in Goodman 2015.

 

In short, SIVs, CDOs, and private label MBS were all effectively shadow banks that provided financing to the real economy during their lifetimes, but were not structured in a way that made them viable long term products. Thus, they disappeared as soon as they were exposed to an adverse environment. When this happened, the funding they had provided to the real economy disappeared (see Mian and Sufi 2018). This showed up as funding stress on the market.

Despite the stress the failures of these vehicles put on markets, the consensus seems to be universal that the Federal Reserve’s job was to protect the regulated banks, not to worry about the disappearance of the “market-based” lending structures. On the other hand, the liquidation and deterioration of these products sent waves through financial markets from August 2007 on that the Federal Reserve and the other central banks had to navigate.

The 2007-09 crisis: not a panic, but the collapse of shadow banking models

This post is a response to Ben Bernanke’s retrospective on the crisis and also addresses some of the comments others have made on his retrospective.

But first let me start the post with a little etymology. The term “lender of last resort” is generally acknowledged to have originated with Francis Baring’s 1797 tract, Observations on the Establishment of the Bank of England. Baring, however, did not use the English phrase; instead he called the Bank of England, the dernier resort. The use of the French is telling, because it is a well-established French phrase referring to the “court of last appeal.” Thus, the etymology of the phrase “lender of last resort” indicates that this is the entity that makes the ultimate decision about rescuing a firm or affirming the market’s death sentence. In short, when we talk about the central bank as lender of last resort, we are talking about the final arbiter of which troubled firms have a right to continue to exist in the economy.

Why would a lender of last resort allow some firms to fail? Because in an economy where bank lending decisions can expand or contract the money supply, banks that engage in fraud or make dangerously stupid lending decisions affect financial stability. So a lender of last resort has to police the line between good bank lending and bad bank lending. This almost always means that some lenders need to be closed down — preferably before they destabilize the financial system.

Framing the lender of last resort as having a duty to determine which of the entities that are at risk of failing for lack of funding will survive and which will not, sheds light on the debate between Ben Bernanke, Paul Krugman, Dean Baker, and Brad Delong. The key to this is to reframe Ben Bernanke’s “panic” which he describes as lasting from August 2007 to Spring 2009 as the process by which the Federal Reserve allowed certain shadow banks — which had no reasonable expectation of Federal Reserve support — to collapse completely.

I. “Financial fragility” was initially driven by the collapse of non-viable funding models

  1. Collapse of shadow banking vehicles (for details see this post)

In 2007 most of the commercial paper segment of the shadow banking system collapsed. These shadow banks included SIVs, and a few CDOs. (The commercial paper collapse was extended over three years, apparently due to Fed approved bank support of the market.) Several categories of commercial paper issuer entirely disappeared.

From 2007 to 2008 several other categories of shadow bank collapsed and disappeared. Some can be classified as existing only due to the excesses of the boom: e.g. Leveraged Super Senior CDO, Constant Proportion Debt Obligations, CDO squared, and ABS CDO. (The  latter two products are best described as combining the return of a bond with the risk of an equity share. Once investors figured this out, they ran for the hills.) Others, such as Private label mortgage backed securities, are less obviously flawed products, and yet 10 years after the crisis are hardly to be found.

All of these shadow banks were “market-based” products with no claim whatsoever to Federal Reserve support, so it was unremarkable that the Fed allowed them to collapse. On the other hand, they had been used to provide funding to the real economy. So their collapse was necessarily accompanied by a decline in real economy lending.

To describe this phenomenon of the collapse of non-viable shadow bank lending models as a “panic” is inaccurate. Lax financial regulation allowed non-viable entities to play a significant role in funding real activity pre-crisis. These entities failed when reality caught up to them. They did not fail because of a panic, they failed because they were non-viable. Because of the significant degree to which banks were exposed to these non-viable shadow banks, short-term funding costs rose more generally, but to a large degree rationally.

2.  End of the 2000’s investment banking model

Over the final decades of the 20th century U.S. investment banks transformed themselves from partnerships into corporations. As corporations they grew to rely much more significantly on borrowed funds than they had when partners’ capital was at risk. By 2007 the investment bank funding model in the U.S. relied extremely heavily on repurchase agreements, derivatives collateral, and commercial paper. Arguably, this was another non-viable shadow bank model.

Bear Stearns failed in March 2008 because of runs on these instruments. Lehman Brothers failed in September for similar reasons. Merrill Lynch was purchased by Bank of America in an 11th hour transaction. Morgan Stanley and Goldman Sachs were at the edge of failure, but saved by the Federal Reserve’s extremely fast decision to permit them to become bank holding companies with full access to the Federal Reserve’s lender of last resort facilities.

While some may believe that financial stability would have been better served by the Federal Reserve’s support of the 2000’s investment banking model, at this point the question is an unanswerable hypothetical. Because the Federal Reserve exercised its lender of last resort authority to refuse to support the 2000’s investment banking model, this shadow banking model no longer exists.

Thus, in September 2008, just as was the case in earlier months of short-term funding pressures,  a major cause of these pressures was real (though in this case elements of “panic” were also important): i.e. the collapse of a shadow banking model that was non-viable without central bank support. Once again, the fact that such a collapse had real effects is not at all surprising.

II. “Financial fragility” did culminate in a well-managed, short-lived panic

Unsurprisingly the collapse of the 2000’s investment banking model was such a significant event that it was in fact accompanied by panic. It is in the nature of a financial panic that it is best understood as the market’s expression of uncertainty as to where the central bank will draw the line between entities that are to be saved and those that are allowed to fail. Effectively, funding dries up for all entities that might hypothetically be allowed to fail. As the central bank makes clear where the lines will be drawn, the panic recedes. This view is supported by the programs that Bernanke lists as having had a distinctly beneficial effect on crisis indicators (p. 65): the Capital Purchase Program, the FDIC’s loan guarantee program, and the announcement of stress test results were all designed to make it clear that depository institutions would be supported through the crisis. Similarly, the support of money market funds gave confidence that no more money market funds would be allowed to “break the buck.”

As Bernanke observes “the [post-Lehman] panic was brought under control relatively quickly” (p. 65). Within six weeks funding pressures had already begun to ease up and by the end of 2008 they had almost entirely receded. In short, once it was clear which entities would be saved by the lender of last resort, there was no longer any cause for panic.

Brad DeLong in a review of Gennaioli and Schleifer’s new book argues that there might not have been a panic associated with Lehman’s failure if some form of resolution authority had been in place. With this I agree. As I argued here: it is almost certainly the case that if Treasury had reacted to the March 2008 Bear Stearns failure by carefully drawing up a Resolution Authority instead of the 3-page original TARP document, 2008 would have looked very different indeed. I also agree with DeLong’s positive evaluation of Gennaioli and Schliefer’s theory of investor psychology. In my view, however, their theory is more properly framed as putting modern bells and whistles on financial market dynamics that have been well-understood for centuries. The whole point of having a central bank and a lender of last resort is, after all, to control the dynamics generated by investor psychology (see e.g. Thornton 1802).

III. Additional bubbles explain Bernanke’s “non-mortgage” credit series

Ben Bernanke focuses on the housing bubble, but there were actually three bubbles created by the shadow banking boom of the early naughties: the housing bubble, the commercial real estate (CRE) bubble, and the syndicated loan “bubble”. SIFMA’s Global CDO data shows how MBS was only one form of shadow banking collateral. Lending to corporations was almost equally important.
Global CDO collateral
As Dean Baker points out the CRE bubble peaked in September 2007. Commercial real estate prices dropped by over 30% over the course of the next 18 months.

The syndicated loan “bubble” has behaved differently. While the market was subject pre-crisis to a deterioration in loan terms that was comparable to the mortgage or CRE market, this “bubble” never popped. The length of the loans was such that not many matured in 2008, and many corporations had committed credit lines from banks that they were able to draw down. Thus, it was in 2009 that concerns about likely corporate defaults weighed heavily on the market (see here and here). These concerns were, however, never realized. The combination of ultra low interest rates, retail investors shifting their focus to bond funds and ETFs, and pension funds reaching for yield meant that corporations were typically able to refinance their way out of the loans, and no aggregate collapse was ever realized. (To see how short lived corporate deleveraging was, see here.)

Thus, the fact that 2009 was a year in which massive corporate bankruptcies were expected just over the horizon probably explains a lot of the stress exhibited by Bernanke’s non-mortgage credit series (which is composed of non-financial corporate credit indicators and consumer-oriented securitization indicators). Treating this series as representing “a run on securitized credit, especially non-mortgage credit” (p. 46) as if it can only be explained by “panic,” does not seem to address the deterioration of corporate fundamentals and the implications of those fundamentals for corporate employees.

Bernanke considers the possibility that borrower financial health drives this indicator, but rejects this explanation, because:  “First, aggregate balance sheets evolve relatively
slowly, which seems inconsistent with the sharp deterioration in the non-mortgage credit factor after Lehman, and (given the slow pace of deleveraging and financial recovery) looks especially inconsistent with the sharp improvement in this factor that began just a few months later” (p. 41). Bernanke appears to assume that the deterioration would have been driven by the housing bubble, but that is not my (or Dean Baker’s) claim. I am arguing that the collapse of the CRE bubble and the weight of needing to refinance maturing syndicated loans in an adverse environment caused corporate balance sheet deterioration. The improvement is then explained by the fact that CRE prices bottomed in mid-2009 and in early 2009 the Federal Reserve made clear its commitment to keep interest rates ultra-low for “an extended period” of time. Both of these helped corporates deal with their debt burden.

In short, I find that Ben Bernanke’s data is entirely consistent with the presence of only a short-lived panic in late 2008. The economic deterioration that Bernanke associates with the prolonged short-term funding crisis and the more short-lived non-mortgage credit crunch can be explained respectively by the collapse of a large number of shadow banking vehicles and by the deflation of the other two lending booms associated with the crisis.

IV. Why Ben Bernanke’s characterization of the crisis is problematic

Thus, my most serious objection to Ben Bernanke’s characterization of the crisis is that, having exercised the lender of last resort authority appropriately to its full potential by permitting shadow bank funding models that were deemed destabilizing to collapse, he seems to want to avoid acknowledging the actual nature of the central bank’s lender of last resort role. His description of the 2007-09 crisis as “a classic financial panic” implies that the crisis was fundamentally a coordination problem in which the public was choosing a bad equilibrium and just needed to be redirected by the central bank into a good equilibrium in order to improve economic performance. Brad DeLong also embraces the language of panic in his response to Bernanke on the AEA Discussion Forum: “all that needed to be done was to keep demand for safe assets from exploding.”

(For Paul Krugman the problem is to explain not just the depth of the recession that ended in mid-2009, but the extraordinarily slow recovery from that recession, which he dubs “the Great Shortfall”. I suspect much of the explanation for the Great Shortfall will be found in post-crisis policies that were designed to protect Wall Street balance sheets at the expense of pension funds and the public, but that is a very different post.)

If one reframes Bernanke’s data from August 2007 to Spring 2009 as representing the complete collapse of certain shadow bank funding models, we see the Federal Reserve as the ultimate decision maker over which funding models were allowed to survive. Because some shadow bank funding models were allowed — properly — to collapse short-term funding rates skyrocketed and areas of the real economy that had adapted to rely upon the doomed funding models struggled as they had to adjust to a world with a different set of choices. This adjustment was temporary because the Federal Reserve — properly — acted to promote restabilization of a financial system without the terminated shadow banks.

What drove the data was not the public choosing a bad equilibrium, (that is, a panic), but the Federal Reserve properly exerting its authority by allowing market forces to eliminate certain shadow banks. This authority is properly exercised because in a world with credit-based money such as ours, financial stability is only possible if the lines between bank-like lending that is acceptable and bank-like lending that is not acceptable are strictly drawn and carefully policed. Thus, the Federal Reserve’s most significant error was its failure to exercise this authority stringently enough long before the crisis broke in order to act preventively to forestall the financial instability that was experienced in 2007-09.

That said, Bernanke is rightly proud of the speed with which the post-Lehman panic was brought under control and is right to conclude that “the suite of policies that controlled the panic likely prevented a much deeper recession than (the already very severe) downturn that we suffered” (p. 66). He also draws a lesson from the crisis that is entirely consistent with the view of it presented here: “continued vigilance in ensuring financial stability” is absolutely necessary. Indeed, I suspect that he would agree with me that that the Federal Reserve should have exercised greater vigilance prior to 2007.

How to evaluate “central banking for all” proposals

The first question to ask regarding proposals to expand the role of the central bank in the monetary system is the payroll question: How is the payroll of a new small business that grows, for example, greenhouse crops that have an 8 week life cycle handled in this environment? For this example let’s assume the owner had enough capital to get the all the infrastructure of the business set up, but not enough to make a payroll of say $10,000 to keep the greenhouse in operation before any product can be sold.

Currently the opening of a small business account by a proprietor with a solid credit record will typically generate a solicitation to open an overdraft related to the account. Thus, it will in many cases be an easy matter for the small business to get the $10,000 loan to go into operation. Assuming the business is a success and produces regular revenues, it is also likely to be easy to get bank loans to fund slow expansion. (Note the business owner will most likely have to take personal liability for the loans.)

Thus, the first thing to ask about any of these policy proposals is: when a bank makes this sort of a loan how can it be funded?

In the most extreme proposals, the bank has to have raised funds in the form of equity or long-term debt before it can lend at all. This is such a dramatic change to our system that it’s hard to believe that the same level of credit that is available now to small business will be available in the new system.

Several proposals (including Ricks et al. – full disclosure: I have not read the paper) get around this problem by allowing banks to fund their lending by borrowing from the central bank. This immediately raises two questions:

(i) How is eligibility to borrow at the central bank determined? If it’s the same set of banks that are eligible to earn interest on reserves now, isn’t this just a transfer of the benefits of banking to a different locus. As long as the policy is not one of “central bank loans for all,” the proposal is clearly still one of two-tier access to the central bank.

(ii) What are the criteria for lending by the central bank? Notice that this necessarily involves much more “hands on” lending than we have in the current system, precisely because the central bank funds these loans itself. In the current system (or more precisely in the system pre-2008 when reserves were scarce), the central bank provides an appropriate (and adjustable) supply of reserves and allows the banks to lend to each other on the Federal Funds market. Thus, in this system the central bank outsources the actual lending decisions to the private sector, allowing market forces to play a role in lending decisions.

Overall, proposals in which the central bank will be lending directly to banks to fund their loans create a situation where monetary policy is being implemented by what used to be called “qualitative policy.” After all if the central bank simply offers unlimited, unsecured loans at a given interest rate to eligible borrowers, such a policy seems certain to be abused by somebody. So the central bank is either going to have to define eligible collateral, eligible (and demonstrable) uses of the funds, or some other explicit criteria for what type of loans are funded. This is a much more interventionist central bank policy than we are used to, and it is far from clear that central banks have the skills to do this well. (Indeed, Gabor & Ban (2015) argue that the ECB post-crisis set up a catastrophically bad collateral framework.)

Now if I understand the Ricks et al. proposal properly (which again I have not read), their solution to this criticism is to say, well, we don’t need to go immediately to full-bore central banking for all, we can simply offer central bank accounts as a public option and let the market decide.

This is what I think will happen in the hybrid system. Just as the growth of MMMFs in the 80s led to growth of financial commercial paper and repos to finance bank lending, so this public option will force the central bank to actively operate its lending window to finance bank loans. Now we have two competing systems, one is the old system of retail and wholesale banking funding, the other is the central bank lending policy.

The question then is: Do federal regulators have the skillset to get the rules right, so that destabilizing forces don’t build up in this system? I would analogize to the last time we set up a system of alternative funding for banks (the MMMF system) and expect regulators to set up something that is temporarily stable and capable of operating for a decade or two, before a fundamental regulatory flaw is exposed and it all comes apart in a terrifying crash. The last time we were lucky, as regulatory ingenuity and legal duct tape held the system together. In this new scenario, the central bank, instead of sitting somewhat above the fray will sit at the dead center of the crisis and may have a harder time garnering support to save the system.

And then, of course, all “let the market decide” arguments are a form of the “competition is good” fallacy. In my view, before claiming that “competition is good,” one must make a prior demonstration that the regulatory structure is such that competition will not lead to a race to the bottom. Given our current circumstances where, for example, the regulator created by the Dodd-Frank Act to deal with fraud and near-fraud is currently being hamstrung, there is abundant reason to believe that the regulatory structure of the financial system is inadequate. Thus, appeals to a public option as a form of healthy competition in the financial system as it is currently regulated are not convincing.

Bank deposits as short positions: the details

So I’ve finally posted the paper I’ve been working on — a New Monetarist model of bank money — on SSRN. Warning for non-economists: lots of Greek  in this one.

Here’s the title and introduction.

The Nature of Money in a Convertible Currency World

This paper studies the nature of money in an environment where the means of payment is convertible at a fixed rate into the numeraire consumption good. By focusing on this environment we eliminate the possibility that the means of payment changes value over time, and deliberately construct a situation where the price level is disabled as a means of equilibrating the supply of money with the demand for it. To our knowledge no one else has studied such an environment in a Lagos-Wright-type framework. Our goal in this paper is to demonstrate that in this environment the first-best can still be attained – if the means of payment is effectively a naked short of the unit of account.

A naked short has the effect of creating a “phantom” supply of the shorted object that disappears when the short is closed out. We demonstrate here that banks can create this “phantom” supply of the unit of account in the form of acceptances of private debt.[1] This type of bank liability is issued when the bank stamps a private commercial bill “accepted,” and the bank obligation is put into circulation when the borrower makes purchases. Then, when the borrower pays off the loan, the phantom supply of the unit of account along with the outstanding, but contingent, bank liability that was used to create it is closed out.

Why do we model the means of payment as a naked short of the unit of account? We argue, first, that this is the best way to understand the nature of the banking system in its developmental stages. Second, by modelling the means of payment in this way our model demonstrates the efficiency gains that can be created through the introduction of a banking system. Third, by carefully evaluating the incentive feasibility conditions for our bank money equilibria, we are able to relate the monetary system to banking stability. We find that the implementation of central bank monetary policy via interest rates can be explained by the need to stabilize the banking system. Finally, we also find support for the use of usury laws as a means by which policymakers choose amongst multiple equilibria to favor the interests of non-banks over those of banks.

The monetary system modelled in this paper is based on the 18th century British monetary system as described in Henry Thornton (1802) An enquiry into the nature and effects of the paper credit of Great Britain. Privately issued bills function as a means of payment because they are “accepted” as liabilities by the banks that underwrite the monetary system. While these bills were denominated in a gold-based unit of account,[2] as a practical matter there was no expectation that they would be settled in gold. Instead, they were used as a means of transferring bank liabilities from one tradesman to another. Thus, bills that are simultaneously private IOUs and bank liabilities are used to make payment. The non-bank debtor pays off her debt by depositing someone else’s bank-certified liability into her account. (The 18th century monetary system was the precursor of the checking account system and operates just like a system of overdraft accounts.) The bank’s liability on a deposited bill is extinguished when funds are credited to the depositor’s account.

In our model productivity is stochastic, and as a result the demand for money is stochastic. We show that the bank-based money described in our model can accommodate this stochastic money demand so that a first best is attained. Thus, our model can be viewed as a model of the “banking school” view where money is issued on an “as needed” basis at the demand of non-banks.

We argue that the convertible currency environment forces a reconsideration of the nature of money. Typically the monetary literature views money as “an object that does not enter utility or production functions, and is available in fixed supply” (Kocherlakota 1998). Shifts in the price of money equilibrate the economy in these environments. Historically, however, stabilization of the price of money by tying it to a fixed quantity of gold was a foundation of economic success in the early modern period (van Dillen; Bayoumi & Eichengreen 1995). Thus, we consider how money functions in an environment where its price is “anchored”. We show that a solution is for the means of payment to be a debt instrument that is denominated in the anchored unit of account and is certified by a bank. This solution is based on actual market practice in the early modern period.

This approach allows us to reinterpret general results such as Gu, Mattesini, and Wright (2014)’s finding that when credit is easy, money is useless, and when money is essential, credit is irrelevant. While their conclusion is correct given their definitions of money and credit, we argue that this standard definition of money is not the correct definition to apply to an environment with banks. We argue that the means of payment in an environment with banks is a naked short of the unit of account, which would be categorized in GMW’s lexicon as “credit”.

This paper employs the methods of new monetarism. Our model combines an environment based on Berentsen, Camera, and Waller (2007) with an approach to banking that is more closely related to Gu, Mattesini, Monnet, and Wright (2013) and Cavalcanti and Wallace (1999a,b). Our model of banking is distinguished from GMMW because non-bank borrowing is supported not by collateral, but by an incentive constraint alone, and from Cavalcanti and Wallace because our banks don’t issue bank notes, but instead certify privately issued IOUs. We find that for values of the discount rate that accord with empirical evidence, such a payments system can be operated with no risk of default simply by setting borrowing constraints.[3] We start by finding the full range of incentive feasible equilibria of the model, and then discuss how, when there are multiple equilibria, a policymaker may choose between these equilibria.

In this environment competitive banking is incentive feasible only when enforcement is exogenous. In the case of endogenous enforcement, competition in banking typically drives the returns to banking below what is incentive feasible and the only equilibrium will be autarky. This result is consistent with many other papers that have found that the welfare of non-banks is improved when there is a franchise value to banking (Martin and Schreft 2005, Monnet and Sanches 2015, Huang 2017. See also Demsetz et al. 1996).

Thus, the challenge for a policymaker is how to regulate competition in the banking sector so that banking is both incentive compatible – and therefore stable – and also meets the policymaker’s goals in terms of serving non-banks. One solution is to treat banking as a natural monopoly, allowing an anti-competitive structure while at the same time imposing a cap on the fees that can be charged by banks. This solution explains usury laws, which by capping interest rates at a level such as 5%, the rate in 18th century Britain, is able to generate both a robust franchise value for the banks that provide payments system credit and at the same time to ensure that a significant fraction of the gains created by the existence of an efficient means of payment accrue to non-banks. An alternate solution is to impose a competitive structure on the banking industry, but also to set a minimum interest rate as a floor below which competition cannot drive the price. We argue that this is the practice of modern central banks and thus that monetary policy should be viewed as playing an important role in preventing competition from destabilizing the banking sector.

Section I introduces the model of a convertible currency. Section II describes the equilibria of the model. Section III presents the equilibria using diagrams. Section IV discusses the means by which policymakers choose between the difference equilibria of the bank-based monetary system. Section V concludes.

[1] While it would be easy to reconfigure the means of payment to be deposits or bank notes, we believe the monetary function of bank liabilities in this paper is sufficiently different from the existing literature that it useful to present it using an unfamiliar instrument.

[2] For the purposes of keeping the exposition simple, assume that we model the monetary system prior to 1797 (when gold convertibility was suspended).

[3] Indeed, we argue elsewhere that the credit based on precisely such constraints constituted the “safe assets” of the monetary system through the developmental years of banking (Sissoko 2016). Treasury bills, the modern financial world’s safe assets, were introduced in 1877 and modeled on the private money market instruments of 19th century Britain (Roberts 1995: 155).

In search of financial stability: A comparison of proposals for reform

I. The liquidity view
a. Solution: Expansive LOLR
b. Solution: Narrow banking

II. The solvency view
a. Solution: PFAS – the dealer of last resort meets narrow banking
b. Solution: Controls on credit

The vast literature on the financial crisis includes a segment comprised of books that propose reforms to the financial system that are designed to promote financial stability. The initial goal of this post was to evaluate and compare some of the more recent contributions to this literature: Morgan Ricks’ The Money Problem (2015), Adair Turner’s Between Debt and the Devil (2015), and Mervyn King’s The End of Alchemy (2016). In order to help balance the discussion, I am also including Perry Mehrling’s The New Lombard Street (2011), Hal Scott’s Interconnectedness and Contagion (2012), and John Cochrane’s Toward a Run-Free Financial System (2014).

A first basic organizing principle for comparing these proposals is to separate the works by their view of the essential problem to be solved: some argue that we should focus on panics or on avoiding liquidity droughts, whereas others see the fundamental problem as one of solvency or too much private sector debt. Those who take the liquidity view make proposals that fall into two broad categories: the establishment of an expansive lender of last resort, and narrow banking proposals where the government backstops short-term debt. While some proponents of the solvency view also put forth narrow banking proposals, their proposals typically attempt to address the potential danger of too much government support for short-term debt and therefore are distinguished from the liquidity-based narrow banking proposals. Finally some advocates of the solvency view argue that financial stability necessitates controls that limit the private sector’s ability to originate debt.

This post addresses each of these arguments in turn.

The liquidity view

The list of authors who argue that the key to addressing financial stability is to focus on liquidity crises and their prevention is long. Here we will discuss the proposals put forth by John Cochrane, Perry Mehrling, Morgan Ricks, and Hal Scott.

Each of these authors is explicit that in his view the key to financial stability is the prevention of liquidity crises. For example, Morgan Ricks writes: “when it comes to financial stability policy, panics— widespread redemptions of the financial sector’s short- term debt— should be viewed as ‘the problem’ (the main one, anyway). More to the point: panic-proofing, as opposed to, say, asset bubble prevention or ‘systemic risk’ mitigation, should be the central objective of financial stability policy” (p. 3). This view is echoed by both John Cochrane: “At its core, our financial crisis was a systemic run. … The central task for a regulatory response, then, should be to eliminate runs” (p. 197); and Hal Scott: “Contagion occurs when short-term creditors run on solvent institutions, or institutions that would be solvent but for the fire sale of assets that are necessary to fund withdrawals” (CNBC comment) and “contagion, rather than asset or liability interconnectedness, was the primary driver of systemic risk in the recent financial crisis” (p. 293). Perry Mehrling also frames the crisis as fundamentally a matter of liquidity, acknowledging first that it was catalyzed by the decline in collateral valuations, but then explaining: “from a money view perspective, price is first of all a matter of market liquidity, and this perspective focuses attention on the dealer system that translated funding liquidity into market liquidity.” (p. 125).

All four of these authors focus on the fact that the financial system that faced crisis in 2007-09 was constructed upon a foundation of short-term liabilities of non-banks. They differ, however, on the question of whether central bank policy was a cause or a consequence of this financial structure. Both Mehrling and Scott focus on what the Federal Reserve did to address the 2007-09 crisis, whereas Cochrane and Ricks argue that lender of last resort support played an important role in moral hazard and the deterioration of financial institution balance sheets in the decades leading up to the crisis (Cochrane pp. 231-32; Ricks p. 195). Indeed Ricks argues against not just the implementation of last resort lending in the lead-up to the crisis, but even against the traditional lender of last resort, because, first, in his view it functions as a distortionary subsidy to financial institutions and, second, it will fail if these institutions do not have enough of the right sort of collateral (pp. 186-87).

Threading a path between these views I would argue that during the decades preceding and fostering the growth of this financial system built on the short-term liabilities of non-banks, a naïve view of the lender of last resort was promoted by Federal Reserve officials. Alan Greenspan declared that: “The management of systemic risk is properly the job of the central banks. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed, central banks, by their existence, appropriately offer a form of catastrophe insurance to banks against such events” (speech 1998). And through these formative decades Timothy Geithner, who would be President of the Federal Reserve Bank of New York and then Treasury Secretary during the crisis, was learning to ignore moral hazard concerns when dealing with crises (Geithner 2014).

Before exploring the details of the “panic-proofing” proposals, let’s briefly preview the contrary view that the crisis was a solvency crisis, and the critiques that the solvency proponents have to offer of the liquidity view. Mervyn King references Keynes’ exposition of uncertainty, animal spirits, and the fact that “a market economy is not self-stabilizing” to explain that sometimes an interim period of disequilibrium may be part of a necessary adjustment process as it becomes clear that the current pattern of behavior is no longer sustainable and that “the debts and credits that have built up … will eventually have to be cancelled” (pp. 294-323). In short, due to radical uncertainty, liquidity neither is nor should be “a permanent feature of financial markets” (p. 151). He remarks that: “Political pressures will always favor the provision of liquidity: lasting solutions require a willingness to tackle the solvency issues” (p. 368).

Adair Turner is more direct in his critique. His view that modern economies are reliant on too much private sector debt is supported by extensive empirical research (Jorda, Schularick & Taylor 2014, Mian & Sufi 2014), and he argues that those who deny that too much private sector debt has been originated are misled by a “presumption in favor of … as many financial contracts as possible as widely traded as possible [that] was an accepted article of faith” prior to the crisis (p. 29). Thus, from the perspective of Between Debt and the Devil, proponents of the liquidity view are likely to be captive minds who simply cannot conceive of the possibility that the debt that was originated prior to the crisis was in fact unsustainable and will at some time in the future end up in default.[1]

Only Ricks directly addresses and rejects the solvency view. His discussion does not, however, reach the question of whether a systemic panic is a necessary consequence of an environment with an unstable build-up of debt. Instead he focuses on how damaging the panic itself was. Thus, while one can read Ricks as arguing that the problem can be addressed either at the level of the debt bubble or at the level of the panic, the fact that he chooses to address the problem at the latter stage because it is only then that the problem becomes acute indicates that he considers “too much debt” to be a distinctly secondary concern.[2] This approach lends credence to Turner’s view that current modes of thought about finance preclude serious discussion of the problem of too much debt.

Unsurprisingly, neither King nor Turner supports the broad government guarantees that underlie all of the solutions proposed by the liquidity view proponents. Despite the common reliance of all four liquidity view authors on government guarantees to prevent crises, the form that these guarantees take is very different. Perry Mehrling and Hal Scott would implement these guarantees through expansive access to the lender of last resort without requiring major structural reform to the financial system. John Cochrane and Morgan Ricks, by contrast, propose complete transformation of the financial system before they would advocate government liquidity support.

Solution: Expand the role of the lender of last resort

Perry Mehrling’s argument in support of an expansive role for the lender of last resort is premised on the assumption that complete transformation of the financial system is not a practical solution. He writes: the “capital-market-based credit system … is now a more important source of credit than the traditional banking system. I take it as given that this brave new world is here to stay.” (p. 113). Similarly, even though Hal Scott does discuss proposals that place a cap on short-term funding for banks (p. 160 ff), he does not clearly address the possibility that such caps could be applied to non-banks as an alternative to lender of last resort support. In short, Scott implicitly, though not explicitly, adopts Mehrling’s approach: financial stability is a problem of stabilizing a financial system constructed upon a foundation of short-term liabilities of non-banks. (As we will see below, Cochrane and Ricks do not share this view.)

The most famous proponent of the lender of last resort as a form of “panic-proofing” is probably Timothy Geithner, who views 2007-09 as fundamentally a liquidity crisis and argues that the right way to deal with such a crisis is by providing government support to the financial institutions involved until such time as their balance sheets are repaired and they can function without government support.[3] This naïve view of the lender of last resort treats the moral hazard concerns of this central bank function as something that must be ignored during a crisis.[4]

Mehrling and Scott seek to lay analytic foundations for an expansive lender of last resort as a solution to panics. Scott in his book recounts the aggressive actions that did indeed have the effect of saving the financial system from contagion (though many have observe that economic performance subsequent to this bailout of dysfunctional finance has left much to be desired, e.g. Mian and Sufi 2014) and argues that: “History has taught us that contagion is an unavoidable risk of financial intermediation and that a strong lender of last resort is necessary to prevent it” (CNBC). In fact, Scott views the Lehman bankruptcy as a lesson that “to be effective, a central bank lender-of-last-resort must be unlimited and non-discretionary. The current [post Dodd-Frank] regime leaves open the risk that lender-of-last-resort assistance will be withheld from a distressed financial institution at a critical moment, and thus short-term creditors remain incentivized to withdraw in the face of such distress. An explicit guarantee, as opposed to the implied guarantee that existed before Lehman’s failure, assures short-term creditors that they will recover all of their funds, thus removing their incentive to run in anticipation of large losses” (p. 292). He makes clear in a later article that “the ability to lend to non-banks in a crisis is a crucial matter, and will become even more important, as over regulation of banks fuels the further growth of the shadow banking sector” (CNBC).

Perry Mehrling does not advocate for an “unlimited and non-discretionary” lender of last resort. Instead he argues that the Federal Reserve should convert into a regular facility the Primary Dealer Credit Facility, which was a program the Federal Reserve put into place during the crisis to support the value of private sector assets that were used as collateral in the tri-party repo market. (At its peak this facility held more than $60 billion of equities. See PDCF data .) Mehrling argues that the modern capital-market-based financial system needs such a “dealer of last resort” to set a price floor on private sector assets and that any moral hazard concerns created by this proposal can be addressed by careful pricing (pp. 134, 137-38).[5] Mervyn King doubts that central banks can implement such a policy successfully: “one of the most difficult issues in monetary policy today is the extent to which central banks should intervene in these asset markets – either to prevent an ‘excessive’ rise in asset prices in the first place or to support prices when they fall sharply. … I am not sure that their track record justifies an optimistic judgment of the ability of central banks [to do this]” (p. 265).

Overall, proponents of an expansive lender of last resort as a solution to the problem of liquidity crises generally start with the assumption that the existing financial structure cannot change and do not address the argument the existing financial structure is in fact a product of the expansion of central bank guarantees in the 1980s and 1990s. Adair Turner (likely with substantial agreement from Charles Goodhart, Mervyn King, and Martin Wolf) would probably argue that proponents of this view are captivated by pseudo-economic delusions and mistaken ideas that forestall an understanding of the fundamental problem of “too much debt.” In short, critics of the expansive lender of last resort proposal argue that far from stabilizing the financial system, the policy has a history of being destabilizing.

Solution: Narrow banking

John Cochrane and Morgan Ricks are united in their view that, even though excessive origination of debt is a predictable consequence of misguided government support for the financial system, the correct way to address this problem is to focus on run-prone (or short-term) financial claims and to design a monetary system backed by government obligations that will put an end to runs. While both authors favor structural financial reform that would effectively end – or at least severely restrict – private short-term debt, the monetary frameworks that the two authors adopt as they formulate their solutions are very different: Cochrane’s view of money is a fairly direct distillation of Milton Friedman’s approach, whereas Ricks develops more of a practitioner’s view that owes as much to Marcia Stigum and Diamond-Dybvig-type coordination problems as to any particular monetary theorist. The only common ground in the two views of money is that both treat money issued by the government as the anchor of their systems (Cochrane p. 224, Ricks p. 146).[6]

Both Cochrane and Ricks would transform the financial system by aggressively restricting the ability of both banks and non-banks to issue short-term, run-prone debt. In Cochrane’s proposal “demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries”(p. 198). Cochrane would restrict the degree to which any other short-term debt (except for trade credit) could be used to finance intermediaries by imposing a tax on such liabilities (p. 199). The result would be that “Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities [i.e. equity]” (p. 198). Ricks’ plan is more comprehensive because it would entirely prohibit nonbank issue of short-term debt, but somewhat less restrictive because it relies on government guarantees of bank liabilities rather than a mandate that banks hold government debt. Specifically, Ricks restricts the issue of short-term debt (except for trade credit) via “unauthorized banking provisions” that only permit banks to issue such debt, and requires that all short-term bank liabilities be explicitly guaranteed by the government (pp. 201, 235). Ricks’ proposal also imposes bank regulation similar to, but more strict than, what we have today including portfolio restrictions and capital requirements (p. 211). Ricks indicates that this proposal can be viewed as making explicit government guarantees that were formerly implicit (p. 25).

Both Cochrane and Ricks argue that government backing of short-term debt will eliminate the danger of runs (with of course the caveat that we are talking about the right sort of government). Whereas Ricks focuses in some detail on the structure of the monetary system, Cochrane’s emphasis is on the value of ensuring that most financial assets are backed by equity: “For the purpose of stopping runs, what really matters is that the value of investors’ claims floats freely and the investors have no claim on the company which could send it into bankruptcy” (p. 215). Ricks’ critique of Cochrane’s proposal is that he underestimates the demand for money-claims on banks and thus ties the supply of money to the quantity of short-term Treasuries available to back them. The advantage of Ricks’ sovereign guarantees of bank liabilities is that it allows the money supply to be backed in part by private sector assets and thus makes it possible for monetary policy to operate independent of fiscal policy (p. 182).

This significant difference in the two proposals is a consequence of the different monetary frameworks that the two authors employ. As noted above, Cochrane’s approach derives directly from Friedman’s and thus bank money, when it exists, is simply a function of government constraints. Ricks, by contrast, views banks as creating money and thus as playing an important part in determining the money supply. It is this latter approach that motivates Ricks to design a “narrow banking” system that nevertheless can allow for expansion of the money supply independent of government debt. Ricks observes that proposals like Cochrane’s (and Friedman 1960’s) envision a monetary system without a significant role for banks (p. 171).

In short, when Cochrane argues that the costs of his transformational plan are not too large, he does so without first modeling why money claims issued by banks are backed by private sector assets. Not only Ricks, but also Adair Turner, Martin Wolf and Charles Goodhart have argued that there are “positive benefits to private rather than public creation of purchasing power” and indeed, that this structure may play a role in “investment mobilization and thus economic growth” (Turner 188-89; see also Wolf 212-13).

Given that Cochrane – and all those who rely on Friedman’s monetary framework – have not thought through why we have the monetary and banking system that we have, his assertions appear “mystical and axiomatic” to use his own words (p. 223). For example, Cochrane writes that by limiting finance to equity finance “we can simply ensure that inevitable booms and busts, losses and failures, transfer seamlessly to final investors without producing runs” (p. 202). “Liquidity is now provided by the liquid markets for these securities, not by banks’ runprone redemption promises.” 226 This Friedman-esque vision of markets plus government as providing all the liquidity that an economy needs is combined with the remarkable claim that we no longer have a transactions need for bank liabilities.[7] Cochrane asseverates that “technology renders this ‘need’ [for short-term bank debt in transactions] obsolete. … We can now know exactly the prices of floating-value securities. Index funds, money market funds, mutual funds, exchange-traded funds, and long-term securitized debt have created floating-value securities that are nonetheless information-insensitive and thus extremely liquid. Consumers already routinely make most transactions via credit cards and debit cards linked to interest-paying accounts, which are in the end largely netted without anyone needing to hold inventories of runnable securities” (p. 222).

In short, Cochrane, because his theoretic framework is devoid of liquidity frictions, does not understand that the traditional settlement process whether for equity or for credit card purchases necessarily requires someone to hold unsecured short-term debt or in other words runnable securities. This is a simple consequence of the fact that the demand for balances cannot be netted instantaneously so that temporary imbalances must necessarily build up somewhere. The alternative is for each member to carry liquidity balances to meet gross, not net, demands. Thus, when you go to real-time gross settlement (RTGS) you increase the liquidity demands on each member of the system. RTGS in the US only functions because the Fed provides an expansive intraday liquidity line to banks (see Fed Funds p. 18). In short RTGS without abundant unsecured central bank support drains liquidity instead of providing it. (See Kaminska 2016 for liquidity problems related to collateralized central bank support.) In fact, arguably the banking system developed precisely in order to address the problem of providing unsecured credit to support netting as part of the settlement of payments.

Just as RTGS systems can inadvertently create liquidity droughts, so the system Cochrane envisions is more likely to be beset by liquidity problems, than “awash in liquidity” (p. 200) – unless of course the Fed is willing to take on significant intraday credit exposure to everybody participating in the RTGS system. (Here is an example of a liquidity frictions model that tackles these questions, Mills and Nesmith JME 2008). Overall the most important lesson to draw from Cochrane’s proposal is that we desperately need better models of banking and money, so we can do a better job of evaluating what it is that banks do.[8]

Another aspect of money that Ricks takes into account, but Cochrane with his simple Friedman-based monetary framework barely addresses is that banks are able to expose themselves to runnable, short-term debt even when they aren’t financing their balance sheets. Ricks argues: “Our monetary theory of banking … suggests that derivatives dealing is properly the domain of nonbank financial firms,” because “the amount of cash exchanged upfront [and therefore the money provided] is almost always very small in relation to the risk taken” (p. 208). Cochrane would not restrict such off-balance-sheet activities, and argues that “a few regulators” will be able to detect any dangerous behavior since leverage ratios will be very low (p. 216). Of course, one of the lessons of the crisis is that off-balance-sheet bank liabilities can be very large: Citibank (as well as UBS and Merrill Lynch) had to recognize upwards of $50 billion of derivatives exposures in the form of super-senior CDOs when its “liquidity puts” were drawn down (FCIC  Report, p. 260).

When we combine Cochrane’s casual approach to the danger of off-balance-sheet bank exposures with the view that “invoices [and] trade credit … are not runprone contracts” (p. 202), we find that his formulation of narrow banking leaves open the possibility that after his reforms the financial system could regenerate a very old – but not necessarily very stable – form of banking, acceptance banking. Whatever is classified as trade credit in Cochrane’s regime may be accepted or guaranteed by banks or unacknowledged shadow banks – and these acceptances may circulate as money just as they did in the 19th century with destabilizing effect. In fact, Ricks’ proposal is also permissive of trade credit and therefore is subject to a similar critique: nothing prevents nonbanks from guaranteeing trade credit obligations and this is an avenue through which a new, unstable banking system can develop. This analysis points to another common criticism of narrow banking proposals: they may be impossible to design due to the “remarkable ability of innovative financial systems to replicate banklike maturity transformation” (Turner p. 189).

Overall, narrow banking proposals raise very important questions about whether our monetary system can be better designed to avoid liquidity crises, but (i) will be very hard to formulate in a way that precludes their circumvention, and (ii) are probably best read as evidence that we need much better models of money and banking, so that we can actually understand what the connections are between money, bank liabilities and private sector bank assets, before pursuing transformative change.

The solvency view

Transformational reform is also proposed by scholars who believe that the essential problem that must be addressed in modern financial systems is not liquidity, but solvency. “The fundamental problem is that modern financial systems left to themselves inevitably create debt in excessive quantities, and in particular debt that does not fund new capital investment, but rather the purchase of already existing assets” (Turner p. 3-4). Turner argues that when banks expand the money supply by creating debt that is used to purchase existing assets, the result is an increase in the prices of the assets thus purchased, which then justifies an increase in the debt collateralized by the asset – and thus an expansion of the money supply. The ultimate consequence of this “self-reinforcing credit and asset price cycle” is an asset price bubble (p. 6). When the bubble bursts, as eventually it must, the problem is not liquidity, but solvency. The economy is then burdened with an overhang of debt that is either bad in the sense that repayment is not feasible or uneconomic, because the debtor is servicing debt that is greater than the value of the asset. This basic critique of modern finance – and in particular of the finance of real estate – is advocated not just by Turner, but also by Martin Wolf 2014 and Charles Goodhart & Enrico Perotti 2015.

Mervyn King in The End of Alchemy takes a slightly different approach. He argues that “the most serious fault line in the management of money in our societies today” is “the alchemy of banking” or the system by which money “is created by private sector institutions” and then used to finance illiquid and risky investments (pp. 86, 104). In his view, however, it is important to emphasize that the causal force generating “too much debt” was not the banks themselves, but the demand for borrowing to finance real estate investment due to the savings generated by the structural current account surpluses of Asian countries and Germany together with the decline in real interest rates that resulted from deficit countries’ efforts to keep their economies growing when faced by these surpluses (p. 319, 325).[9] In short, while King agrees that we are currently faced with a state of disequilibrium characterized by too much debt, he explains this outcome via a change in our understanding of the state of the world, not via an inherently unsustainable asset price bubble (pp. 356-57).

Proponents of the solvency view believe that not only does financial stability require that our financial structure be transformed, but also that the only path forward will require debt forgiveness of some sort (King p. 346, Turner p. 225ff). Because the focus of this essay is on proposals for transformational reform of the financial system, devices to deal with the debt overhang will not be discussed. Instead we evaluate King’s proposal for a pawnbroker for all seasons and Turner’s argument that direct controls on the financial sector’s origination of debt instruments are necessary.

Solution: PFAS – the dealer of last resort meets narrow banking

Like John Cochrane and Morgan Ricks, Mervyn King focuses his attention on the design of a more stable monetary system. His proposal for a pawnbroker for all seasons (PFAS) combines aspects of the dealer of last resort and narrow banking proposals. In particular, he would allow the central bank to lend against risky collateral, but only upon terms that are specified well in advance, and he would combine this policy with a restriction that all short-term unsecured liabilities of a bank must be backed by a combination of cash, central bank reserves, and the committed central bank credit line.

King motivates his proposal as an improvement over the traditional lender of last resort, which he (like Ricks) views as suffering from a time inconsistency problem: “The essential problem with the traditional LOLR is that, in the presence of alchemy, the only way to provide sufficient liquidity in a crisis is to lend against bad collateral – at inadequate haircuts and low or zero penalty rates. Announcing in advance that it will follow Bagehot’s rule … will not prevent a central bank from wanting to deviate from it once a crisis hits. Anticipating that, banks have every incentive to run down their holdings of liquid assets” (p. 269). But in contrast to some proponents of an expansive lender of last resort, King argues that moral hazard concerns must be addressed ex ante: “It is not enough to respond to the crisis by throwing money at the system … ensuring that banks face incentives to prepare in normal times for access to liquidity in bad times matters just as much” (p. 270).

Specifically, under King’s proposal, as under the dealer of last resort, the central bank provides liquidity against risky assets and does so subject to a haircut, but importantly the PFAS would not just specify the haircut in advance, but would specify it with the expectation of not changing it for years (p. 277). Thus, the first step of the PFAS proposal is that assets must be pre-positioned as collateral for a specific loan amount. The second step of the proposal caps the short-term unsecured debt of the bank by the sum of the cash, the central bank reserves held by the bank, and the amount that the bank can draw from the central bank on the basis of pre-positioned collateral (p. 272). “The scheme would apply to all financial intermediaries, banks and shadow banks, which issued unsecured debt with a  maturity of less than one year above a de minimis proportion of the balance sheet” (p. 274).

King’s proposal addresses two important design concerns. First, even though banks can create money, “only the central bank can create liquidity” or “the ultimate form of money” (pp. 190, 259). For this reason, King finds that “liquidity regulation has to be seamlessly integrated with a central bank’s function as the lender of last resort” (p. 259).[10] This is achieved by using the credit line commitment of the central bank as a determinant of the cap on a bank’s runnable assets. Second, when a central bank increases its collateralized lending to a bank, the bank’s unsecured lenders are disadvantaged and this form of central bank liquidity support can have the effect of reducing the availability of – or even generating a run on – unsecured market-based lending to the bank. For this reason what is needed is a “single integrated framework within which to analyze the provision of money by central banks in both good time and bad times” (p. 208). Because unsecured lenders will know in advance that the pre-positioned collateral will be used to draw from the central bank, they will not expect it to be available to support their own claims and will demand to be paid a rate on the unsecured debt that compensates them for this fact.

This proposal achieves stability in much the same way that narrow banking does: “all deposits are backed by either actual cash or a guaranteed contingent claim on reserves at the central bank” (p. 271). Unlike Cochrane’s narrow banking, however, only indirect control is exercised over the bank’s asset portfolio. In comparison with Morgan Ricks’ proposal, the public guarantee is provided not with respect to the liabilities of a bank but instead with reference to its assets, and it is the central bank – or the ultimate provider of liquidity – not bank regulators who will make the decisions that affect the bank’s asset portfolio.

The issue of the degree of control exercised by the PFAS is, in fact, an interesting question. One of King’s goals is to “design a system which in effect imposes a tax on the degree of alchemy in our financial system” (p. 271). While each bank nominally is left to determine how to allocate its asset portfolio, the central bank has almost total control over how the tax is structured and, in particular, over which assets will be highly taxed and which will not. According to King the central bank “should be conservative when setting haircuts and, if in doubt, err on the high side. … on some assets they may well be 100%. … It is not the role of central banks to subsidize the existence of markets that would not otherwise exist” (p. 277-78). At least to the degree that a financial intermediary finances itself with deposits and other forms of unsecured short-term debt, it would appear that the PFAS will exercise a great deal of control over the assets that are thus financed.

Unsurprisingly End of Alchemy includes a robust defense of central bank discretion (p. 167). Thus, whether or not this proposal is subject to Ricks’ criticism of narrow banking as serving as an excessive constraint on the money supply will depend on the decisions of central bankers and how they exercise the control over the banking system granted to them by the PFAS proposal.

Solution: Controls on credit

Control over the types of assets that are financed by bank credit creation is also the solution that Adair Turner proposes. It is Turner who advocates most strongly for the view that “too much debt” explains the increasing instability of modern economies. Thus, for Turner “the amount of credit created and its allocation is too important to be left to the bankers; nor can it be left to free markets in securitized credit” (p. 104); instead it is necessary for bank regulators to control the growth of credit. Turner argues more specifically that the most important driving force behind instability was the “interaction between the potentially limitless supply of bank credit and the highly inelastic supply of real estate and locationally specific land. … Credit and real estate price cycles … are close to the whole story [of financial instability in advanced economies]” (p. 175).

Thus, Turner proposes that bank regulation should directly constrain certain types of finance including lending against real estate and shadow banking (p. 195). He would also constrain borrowers’ access to credit and slow international capital flows, which when they took the form of short-term debt simply increased the excess of funds flowing into “hot” real estate markets (p. 196).

Constraints on shadow banking are necessary because in the run-up to the recent crisis it had the effect of “turbocharg[ing] the [credit] cycle, [and] increasing the danger of the wrong sort of debt” (p. 90). Like Ricks and King (p. 94), Turner emphasizes that it was shadow banks that caused bank funding markets to seize up when “wholesale secured funding markets went into a meltdown driven by the very risk management tools that were supposed to make them safe” (p. 103).

While Adair Turner does not promote any version of narrow banking, he draws inspiration from narrow banking’s vision of a system where financial assets are financed by equity. Because “in principle the more that contracts take an equity and not a debt form, the more stable the economy will be,” “implicit taxes on credit creation can be a good thing” (p. 192) and “free market approaches to [credit markets] are simply not valid” (p. 190).

Turner’s focus is, however, very different. Whereas John Cochrane argues that there is no need to differentiate between the different types of credit markets (p. 213), Turner emphasizes the importance of the real estate market: Nowadays “most bank lending … finances the purchase of real estate. … [This] also reflects a bias for banks to prefer to lend against the security of real estate assets … [which] seems to simplify risk assessment” (p. 71). As “banks, unless constrained by policy, have an infinite capacity to create credit, money, and purchasing power … [this combination results in] credit and asset price cycles [that] are not just part of the story of financial instability in modern economies, they are its very essence” (p. 73).

Overall, Turner’s bottom line is that “we should not intervene in the allocation of credit to specific individuals or businesses, but we must constrain the overall quantity of credit and lean against the free market’s potentially harmful bias toward the ‘speculative’ finance of existing assets.” This policy “does not mean less growth, since a large proportion of credit is not essential to economic growth” (p. 208).

Conclusion

Discussions of financial stability and how to achieve it are characterized by a remarkable breadth of views. At one extreme are those who believe that modern finance is here to stay and that its stabilization requires a lender of last resort which plays a much expansive role than in the past. Critics of this approach argue that on the contrary, the expansion of the lender of last resort’s responsibilities over the course of the last three or four decades is what generated the modern financial system which is so very unstable.

Some of these critics of the modern financial system emphasize the liquidity problems it generates and others the solvency problems. All, however, are in agreement that, if financial stability is the goal, substantial reform of the modern financial system is necessary.

Proponents of the solvency view explain that the design of the modern financial system is so flawed that the origination of too much debt is a structural problem. As a result proponents of the solvency view find that either regulators or the central bank must constrain the capacity of all financial intermediaries to finance certain forms of debt – and real estate loans, in particular – using short-term instruments.

The proponents of the liquidity view who propose transformational reform of the financial system argue that only government backing of short-term liabilities can stabilize them. They differ on the degree to which banks have a role to play in a reformed financial system, however. And the comparison of these proposals leads me to conclude that we are in desperate need of better – formal, economic – models of money and banking in order to evaluate these questions.

So what’s my bottom line? I’ve been working on a model of money, bank liabilities, and private sector debt that speaks to all these issues. This model demonstrates that banks’ economic function is to underwrite the unsecured debt that makes the payments system work. By doing so banks bring agents who would otherwise be anonymous and autarkic into the economy. In effect, banks are paid enforcers of intertemporal budget constraints – and it is only because they provide this service that you and I can participate in the payments system and therefore in a modern economy. In short, I think we need a “banking school” model to help us tackle these problems. (Warning to Friedmanites: banking school is the devil that it was Friedman’s agenda to exterminate.) The details will, however, have to wait for another day.

[1] While Hal Scott’s opus has been described as showing “that none of the banks that fell or were rescued were important enough to another big institution to cause its failure” (Authers 2016), this fails to address the question of whether the whole system was beset by too much debt. The danger to the financial system of a “bad equilibrium” in which every participant underwrites too much debt has been recognized for decades (Goodhart 1988 p. 48).

[2] He writes: “this chapter offers reason to doubt that debt-fueled bubbles and the like pose a grave threat to the real economy in the absence of a panic” (p. 106) and “my claim is not that debt-fueled bubbles are insignificant … Rather, my claim is that panics appear to pose a far graver threat to the broader economy” (p. 141). This certainly seems to imply that is possible to have debt-fueled bubbles without also having a panic.

[3] In an interview Geithner states: “What’s unique about panics, and most dangerous, is the amount of collateral damage they do to the innocent, to people who had borrowed responsibly, who weren’t overexposed. The banking system is the lifeblood of the economy. It’s like the power grid. You have to make sure the lights stay on, because if the lights go out, then you face the damage like what you saw in the Great Depression … That requires doing things that are terribly unfair and look deeply offensive. It looks like you are rewarding the arsonist or protecting people from their mistakes, but there is no alternative. We didn’t do it for the banks. We did it to protect people from the failures of banks” (Wessel 2014).

[4] For a view of the lender of last resort which is more nuanced see Sissoko 2016. In fact, the origins of the term “lender of last resort” itself indicates that the central bank is rightly the “court of last appeal” which makes the ultimate determination of whether a financial firm is solvent or not. Implicit in the moniker is the idea that central banks should sometimes uphold the market’s death sentence for a financial firm – just as courts must sometimes uphold real-life death sentences (Sissoko 2014).

[5] Cochrane’s dry comment on the expansion of policy to the regulation of prices is: “What did the old lady eat after the horse?” (p. 238).

[6] This is unsurprising given that almost all modern academic analyses of money, including the heterodox literature, also emphasize the role of government in the money supply. Whether or not this consensus is well-founded is a topic for a different post.

[7] Perhaps Cochrane’s view of the capacity of markets to provide liquidity has changed in recent years. He writes in an October 2016 essay titled Volume and Information: “Information seems to need trades to percolate into prices. We just don’t understand why.” which would seem to imply that markets both demand liquidity and provide it.

[8] Indeed, this is clearly Morgan Ricks agenda (see p. 210). The weakness of Ricks’ approach is that he is a legal scholar and the agenda calls for formal economic analysis.

[9] Note that Turner and Wolf both agree that current account imbalances played an important role in generating the asset price bubbles.

[10] Here King is apparently questioning whether the liquidity coverage ratio specified by the Basel III accords makes sense.