Lombard Street: Part Two

Part Two: What Now?

For part one please scroll down

Lombard states two primary measures to be taken in the event of a panic (emphasis added):

“First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.”

Basically, loans should only be made at very high interest rates to discourage those who don’t need loans from taking them. Only those who truly need the loans should take them, preserving the reserves in the banking system.

“Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer… No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business… The great majority, the majority to be protected, are the ‘sound’ people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.”

To summarize, loans should be given to anybody who wants them as long as they have proper collateral. This will prevent the public from being alarmed and from losing confidence in the banking system.

These measures were compelling in the 19th century. However, it is important to note—particularly in regards to the first measure—that they are largely a function of the gold standard. At that time the monetary supply could not be manipulated by the central bank as it was based purely on the amount of gold they held. As a result it made sense to raise interest rates so that only those who were most in need of the reserves would borrow money while also deterring those those who do not truly need it from borrowing and wasting the reserves.

The second point involves being sure to continue to lend money to firms with strong fundamentals. If a bank refuses a loan to a firm with strong collateral it will spark a panic. At the time Bagehot wrote this it was a great idea. Now, however, the Federal Reserve has the ability to increase the supply of money. The inevitable conclusion of the change from metallic to fiat currency is that Bagehot’s policies are no longer directly applicable, but his general observation of the market is still theoretically strong.

While quantitative easing, less lending, FDIC guarantees, and cheaper rates all have the ability to restore confidence in today’s world if executed correctly, this does add a new problem.  Bagehot speaks in depth of those banks and firms that are rotten (insolvent) and how we need let them fail while saving the other that are just suffering from low liquidity. Bagehot thought that those firms with strong collateral would simply survive while others would not as interest rates were raised. There are two separate equilibriums, however, that Bagehot claims must be met: First, it must be high enough to attract gold from other countries so the reserves are not depleted. Second, it must not be so high as to cause solvent firms to go bankrupt due to low liquidity. Luckily, with the rise of fiat money, we no longer need to worry about running out of reserves. So the idea would be we can let insolvent firms fail by setting interest rates at a point where insolvent firms fail and those who are just suffering because of a liquidity crisis survive.

However, as seen in 2008, it can become difficult to discern those banks and firms that deserve to fail and those that do not deserve to fail. Often, the reason a failure occurs is structural or due to poor incentives or due to government policies, leading many firms to take on a level of risk that should not exist in the free market (also known as an externality called counter-party risk). A simple example would be the existence of the FDIC $200,000 guarantee allowing banker/dealers to take on more risk than normal. Another reason may be due to many firms holding similar assets. If one firm collapses and is forced to sell an asset it will drive down the prices of the asset, damaging the balance sheets of other banks and potentially causing them to fail. When a panic or crises occurs and the entire system seems prepared to collapse it is not possible to simply save the good and let the bad fail. It becomes difficult to distinguish between the two and how they are connected. The rotten and toxic parts of the system are not as easy to destroy as Bagehot suggests, especially if the goal is to save the healthy parts. It is possible that keeping a toxic bank alive (an insolvent bank) is necessary to keep five other, healthy banks alive. This was seen with firms such as AIG that had insured so many banks that their demise would have been catastrophic for the system. However, AIG was selling insurance based on faulted risk models and for that they did deserve to fail. It is still possible that some might argue that firms that trusted AIG made a poor business decision and deserved to suffer. The question of who deserves to fail is not easy to answer and even if a short-term efficient economic model is found it might have moral hazard consequences in the long run (many people believe, for example, that the “too big to fail” doctrine will encourage large banks to take on more risk since they can expect to be bailed out by the government if they do fail).

Bagehot also says that “under a good system of banking” a collapse would not happen except from rebellion or invasion. I guess if a bank system does collapse, then it wasn’t good, so Bagehot can never be wrong on this point. It all depends on what characteristics define a “good” system of banking. To his credit he explains further that good banks will always keep a large reserve due to the demand of depositors, and that in a panic they will advance out their reserve boldly and largely to show their strength. Still though, so far, he is right. For all the failures of 2008 our currency did not collapse. While Bagehot could not anticipate the changes in central banking and the banking system that would occur between 1873 and 2008, his theory still held. An incredible sign of a robust theory.

-Simon

3 thoughts on “Lombard Street: Part Two

  1. “However, as seen in 2008, it can become difficult to discern those banks and firms that deserve to fail and those that do not deserve to fail.”

    I agree, but I got the feeling watching the collapse from the outside that this opacity was a feature rather than a bug. More properly, it seems as though as many financial institutions had distress from sources they could not understand as were incented to hide the sources of their distress. The consensus view seemed to be that the financial crisis was a short term liquidity crisis and not a solvency/informational crisis. Consequently the right answer seemed to be obscure the extent of losses in the hopes that short term credit extensions would reappear after a few months.

    • A feature huh? I do remember in summer of 2011 they released the ‘true’ figures of the crisis, and it turned out it was far worse than it really was. I think many people did have a sneaking suspicion that at the time they might have presented the ‘best case scenario’ as the ‘true scenario.’ It isn’t hard to believe. It seems that the peak of the crisis was almost entirely short-term liquidity. But the firms that over-leveraged and created too many asset backed securities (WaMu) probably did deserve to fail. It’s just shades of gray though. The debate of who deserved to fail vs. who didn’t is a moral argument not an economic one. If that makes sense. I’m at work and it’s early so this is more rushed than it would be normally. I just really wanted to make sure I got a response in to thank you for your comment and support on reddit 🙂

  2. If anyone is interested in reading about the quantitative side of the crisis then you might want to check out a paper by Scott Mixon titled Model Risk: Lessons From Past Catastrophes. I found it to be a pretty easy read with just enough technical and just enough abstract to understand it without being bogged down by high level math.

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