Is this LOLR? No it’s a trap

In the 1983 film Return of the Jedi, Admiral Akbar turns to the officers on the bridge and says what everyone already knows: trap!” It seemed too easy to be able to destroy the main threat forever and without risk. Of course, this backfired badly on the Alliance; they were not to be deceived.

Dodd-Frank and other new rules were to fix the banking system permanently and without risk. But then again, it was too good to be true, and it turned out that all the new rules did was set another trapalthough not intentionally (although benefits for large firms are at least partially intentional). The solution to effective banking regulation is to understand the role of the “lender of last resort” and commit to doing nothing more, no matter what. ass Richard Salsman and I discussed the Too Big to Fail alternative over a decade ago.‘ turned out to be disastrous.

Bank regulation method: lender of last resort

Banks and many other financial institutions too brokers, mediation in transactions between people who have money – savers – and people who want to get loans to do something with money – borrowers. Brokers usually don’t hold money that they have deposited; The value of a brokerage lies in connecting that money with an investment. In fact, the banking business has long been described as a sleepy but safe activity that follows “Rule 3-6-3”:

• 3 percent – interest you pay on deposits
• 6 percent is the rate you charge on loans
• 3pm is your daily golf course time because this business runs on its own

Banks package and sell a product called liquidity. Liquidity is a measure of how quickly and cheaply an asset can be used to buy something else. Important, liquidity is not money, but a measure of the demand for cash balancesrather than holding wealth in some other form. Still cash is liquid. It’s easy to negotiate a price, and transferring ownership is cheap. Loans are (usually) illiquid. Loans (such as mortgages) are contracts that link one party to another, requiring payments backed by an asset. For example, in the case of a mortgage, the loan is secured by the value of the house, which means that a much lower interest rate can be negotiated than with an unsecured personal loan because there is less risk to the lender.

It is possible to buy and sell loans, stocks or other securities, but this is much more expensive than paying in cash. (This illiquidity was part of the reason mortgage-backed securities seemed such a good idea because, at least in theory, they were liquid; in fact, it appears that mortgage-backed securities have been fairly liquid, and have retained their value better than is sometimes described). Another form of loan is called a “bond”, which is a promise to make periodic payments over a specified period and then repay the full amount of the loan, the principal, at the end of that period. For example, ten-year US Treasury bonds have a face value and an implied interest rate paid to the purchaser of the bond.

As I said earlier, banks are brokers. They take deposits and then use those deposits to “buy” loans. The bank may be the originator of the loan, as is the case with many mortgages. Or a bank can literally buy bonds or other securities, financial instruments that earn a higher rate of return than just holding money.

The problem is obvious. There may be a liquidity mismatch between the bank’s liabilities (depositors deposit cash and they want to be able to withdraw cash) and assets (loans, bonds, other securities of various kinds). It’s easy to imagine situations where a bank would be technically solvent – the total value of all of its assets exceeds the value of all of its liabilities – but the bank can’t convert enough of those valuable assets into cash fast enough to let everyone get out of their money right now. And when everyone wants their money right nowthis is called a bank run.

The bank run is dramatic and has been used in films ever since It’s a wonderful life To Mary Poppins. (May be fun to use these movies in class, as an illustration!) The reason people rush to get their money is because there isn’t enough of it, and if you put it off, you’ll lose. The political problem is that enough valuesimply no enough money, Today. This is why the lender of last resort (LOLR) function is so important. All it takes is a short term loan to have enough cash today.

The cool thing about the LOLR solution – and note that LOLR can be a private central clearing house or cash vault that keeps value in liquid form for immediate payout – is that if people trust LOLR to act immediately and efficiently, then the LOLR entity should never act at all. If I know that I can get my money today, or, for that matter, tomorrow or the day after tomorrow, because the bank will not run out of money – he can’t run out of money – then I don’t try to withdraw my money at all.

Walter BaghotLombard Street1873) put forward a very reasonable argument that many financial crises are not due to insolvency, but only to illiquidity. And illiquidity is only a problem if literally everyone wants to withdraw their money from the bank at the same time. This problem is that “everyone wants to withdraw their money at the same time” is literally the definition of a bank run, when depositors rush to get their cash while there is still cash.

Badgehot (pronounced “BADGE-uht”) stated that a LOLR should dedicate himself entirely to doing three things and never do more than these three things:

1) Borrow as much money as needed directly to troubled (temporarily illiquid) banks; 2) B penalty rate (much higher than the market interest rate) 3) But only against good pledgeas suggested by a technically solvent bank.

Since there is immediate, unlimited availability of cash, there will be no bank runs. Because the interest rate is high, the loans will be very short term. And since the bank has enough assets to cover its liabilities, there is no problem getting longer-term loans if necessary. Lending to provide liquidity is cheap and efficient, but it’s not a lifesaver because the bank has equity, it just doesn’t have enough liquidity.

The disadvantage of using Bagehot LOLR’s solution exclusively is that it does nothing to solve “financial contagionwhen troubled banks suffer not just from a lack of liquidity, but from complete insolvency. I learned about “contagion” as part of my professor Hyman P. Minsky’s “contagion” theory.fragilityin the financial system, so I lean towards his definition of contagion as a cascade of failures caused by the failure of one or more financial institutions to meet their obligations. When these assets depreciate, other banks immediately become technically insolvent, although they were solvent just an hour ago. Failures spread like falling dominoes, quickly causing massive financial failures.

The reader will probably notice that the US has abandoned the Bagehot rules in favor of trying to limit contagion. Our LOLR, made up of the Federal Reserve and the Treasury Department, routinely and willfully abuses the powers given to central banks. In their defence, however, Baghhot’s criteria are politically unviable because failing banks that flaw good collateral is just as contagious, perhaps more contagious, than banks with good collateral.

If LOLR’s job is to prevent infection, which is how regulators describe their work – then it is logically impossible to adhere to the third rule of Baghhot, lending only to solvent banks that need liquidity. But this changes everything. Without limiting the requirement of good collateral, LOLR is insurer The last resort is a reserve for savers who have no reason to take risk into account when deciding whether to place their funds. This problem is greatly exacerbated by “deposit insurance” guarantees, which now extended far beyond the $250,000 limit to be practically unlimited.

That’s all what happened to Silicon Valley Bank depositors, and Signature Bank (and possibly other banks by the time it arrives). All deposits were guaranteed by the taxpayers, although the banks were insolvent, not illiquid. The usual story was that the deposits were guaranteed by the “government”, but that’s nonsense. The money is taken from taxpayers and used to support savers who have made a bad bet on where to invest their money.

Since our regulatory practice has moved beyond lending to illiquid but solvent banks to returning all deposits from insolvent banks, the result is that depositors have no reason to worry about whether their bank is taking excessive risks. It is called “moral hazard” because it encourages the most risky for which regulators later ask taxpayers to pay.

The problem of moral hazard sounds mysterious, but it is a trap. In the case of a Silicon Valley bank, the risks in the bank were not even intentional, but revealed a striking lack of knowledge basic financial principles relating to the capital value of bonds in times of inflation. In fairness, it should be said that the shareholders of the bank itself were punished by market forces (maybe if Treasury doesn’t lose his temperand lends itself political pressure from the union and state pension funds. Stay tuned!) because their equity is worth nothing. But investors should have been more careful. And they would be more careful were it not for the fact that the deposits are insured by taxpayers who have no say in foolish risk rewards. Even worse, the fact that deposits above the legal limit of $250,000 are covered by taxpayers means that we are signaling to other depositors that they should not look at their own banks because taxpayers will also cover those deposits. .

The reason this is infuriating is that we are told that taxpayers should be willing to double down to compensate even more careless savers for their careless inattention to risk. And I think you can see why, given that this dangerous assumption is now built into expectations about how regulators will behave.

As Obi-Wan told Luke, also in Return of the Jedi: “What I told you was true from a certain point of view.” But Luke was furious at being lied to, and you should be, too.