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The Fed strangles it in an attempt to save capitalism

BusinessEconomyThe Fed strangles it in an attempt to save capitalism
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MAbout this The collapse of Silicon Valley Bank has been extremely modern. Name of bank. Client base of tech-focused venture capitalists. Tweet creates panic Cash withdrawal through smartphone. At its root, however, the lender’s collapse was just the latest iteration of a classic bank run. And the solution, a central bank stepping in to backstop the financial system, was also time-honored. The subject of economics is so old that the lyrical phrase describing the functions of the central bank, the “lender of last resort”, is often reduced to its obscure acronym, Lol,

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A review of the history in the case of Silicon Valley Bank shows it to be both typical and unique. There is ample, albeit imperfect, precedent for the Fed’s actions. Yet they continue to have a worrying trend of ever-widening interventions and resulting distortions in the financial system. This raises questions about whether, in the long run, the Fed’s quest for stability hurts the economy.

it would be remiss to have a column economist to ignore the person who is often credited with first articulating the theory Lol: Walter Bagehot was the editor of this paper in the 19th century. Over the years, his ideas evolved into a rule for how central banks should manage panics: Lend quickly and freely at punitive rates against good collateral. As Sir Paul Tucker of the Bank of England has previously said, the argument is twofold. Knowing the central bank stands behind commercial lenders, depositors have less incentive to flee. If a run occurs, intervention helps limit the selloff.

The obvious objection is as old as Bagehot’s writings. Lol: Of moral hazard. Prior knowledge of central bank intervention can motivate bad behavior. Banks will hold on to less liquid, lower yielding assets, rather than continue to accumulate in higher-risk lines of business. How to prevent panic without sowing new threats is perhaps the central question facing financial regulators.

The clearest evidence of the need for some kind of financial backstop comes from the past-Lol Year. There were eight American banking panics in the half-century between 1863 and 1913, each dealing a severe blow to the economy. The government responded by creating the Federal Reserve System in 1913. It was only after that crisis that America established a true Lol framework. Power was concentrated at the heart of the Fed, while the federal government initiated deposit insurance. Banks were bound by other means, such as deposit-rate caps, to limit moral hazard. it’s normal Lol Since then Template: Officials provide support and impose limits. Striking the right balance is a difficult task.

In the decades following the Great Depression, it seemed that the Fed had put an end to the bank run. But in the 1970s, when inflation soared and growth moderated, the financial system came under pressure. At each opportunity the officials expanded their playbook. In 1970, he solved the problem that arose outside the banking system. In 1974, he auctioned off a failed bank. In 1984, he guaranteed uninsured deposits. He liquidated the banking system after the stock market crash in 1987. In 1998, he helped open the hedge fund. Even though each episode was different, the basic principles were consistent. The Fed was willing to let some dominoes fall. Eventually, though, this will set off the chain reaction.

These various episodes were dress rehearsals for the Fed’s maximalist responses to the 2007-09 global financial crisis and the 2020 Covid crash. Both times it extended a dizzying array of new credit facilities to struggling banks. It directed funding to troubled corners of the economy. It accepted a broad range of securities as collateral, including corporate bonds. It allowed large firms to fail—most importantly, Lehman Brothers. And it pulled back most of its support as soon as the markets started moving again.

Such widespread interventions have prompted a reconsideration of the moral hazard. The concern in the 1970s was over-regulation. Instead of making the financial system safer, policies such as deposit-rate caps had driven activity toward shadow lenders. Little by little, regulators eased the restrictions. But after the financial crisis, the pendulum swung back towards regulation. Big banks must now hold more capital, limit their trading and undergo regular stress-testing. The massive support from the Fed has come with tighter limits.

In this context, the government’s response to Silicon Valley Bank looks more like another notch in the wall rather than a radical new design. This is hardly the first time that uninsured depositors have escaped financial disaster. Nor is it the first time that the Fed has bailed out some failing banks before launching a credit program that is likely to rescue similar firms.

hazard lights

Yet every notch in the wall is also a sign of an increasingly bullish Fed. In one important respect, its aid has been far more abundant than that of previous defences. When providing emergency loans, it is generally conservative in its collateral rules, using market prices to value the securities that the bank hands over in exchange for cash. Also, it aims to lend only to solvent firms. This time, however, the Fed accepted government bonds at face value, even though their market value had fallen sharply. It is worth mentioning that. If it had to forfeit the collateral, it may incur a loss in terms of present value. And the program could revive banks that were insolvent at mark-to-market terms.

The Fed has no desire to make its latest changes permanent. It has also limited its special loans to just one year – which officials hope is enough to stave off the crisis. If they get their way, peace will finally return, investors will shrug their shoulders and banks will be back in business without the need for Fed support. But if they don’t and more banks fail, the Fed will be left with underwater assets on its books, absorbing financial losses that would otherwise have been market-related. The lender of last resort runs the risk of turning into a loss-making first resort.

Read more from our column on economics Free Exchange:
Emerging-market central-bank experimentation risks rekindling inflation (March 9)
The case against Google hinges on an antitrust “mistake”. (2 March)
What would the perfect climate-change lender look like? (23 February)

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