riceabout The collapse of Silicon Valley Bank has profound modern implications. The name of the bank. Client base for tech-focused venture capitalists. The tweets sparked panic. Withdraw cash from your smartphone. The point, though, is that the lender’s downfall is the latest iteration of a classic bank run. The solution of central banks stepping in to support the financial system also has a long history. The topic in economics is so corny that the lyrical phrase “lender of last resort” describing the behavior of central banks is often shortened to its clumsy acronym, Ha ha.
Looking back at history, the case of Silicon Valley Bank is both typical and unique. There is ample but imperfect precedent for the Fed’s actions. However, they continued a worrying trend of increasingly widespread intervention and, as a result, distorted the financial system. That raises questions about whether the Fed’s quest for stability will hurt the economy in the long run.
It would be an oversight of a column economist Ignoring the person who is usually credited with first formulating the theory Ha ha: Walter Bagehot, editor of this newspaper in the 19th century. Over the years, his ideas evolved into rules for how central banks should manage panics: Lending quickly and freely at punitive rates, with good collateral. As the former Bank of England’s Sir Paul Tucker put it, the logic is twofold. Knowing that the central bank backs commercial lenders gives savers less incentive to flee. If a run does occur, intervention can help limit the sell-off.
Almost as old as Bagehot’s work is the apparent objection Ha ha: Moral Hazard. Anticipation of central bank intervention can lead to bad behaviour. Banks would hold onto less liquid, lower yielding assets and instead pile into riskier areas of the business. How to prevent panic without sowing new dangers may be at the heart of the question facing financial regulators.
The clearest evidence for the need for some form of financial support comes from forecastHa ha Year. In the half century from 1863 to 1913, there were eight banking panics in the United States, each of which hit the economy hard. The government responded by creating the Federal Reserve System in 1913. But by breaking up into regional fiefdoms, it was too timid in dealing with the Great Depression.Only after that crisis did the United States establish a real Ha ha frame. Power was concentrated at the center of the Federal Reserve, and the federal government introduced deposit insurance. Other tools, such as caps on deposit rates, constrain banks in order to limit moral hazard.this has been kept generally Ha ha Template hereafter: Authorities provide both support and restrictions. Getting the balance right is extremely difficult.
In the decades following the Great Depression, the Federal Reserve appeared to have ended bank runs. But starting in the 1970s, when inflation soared and growth slowed, the financial system came under pressure. Officials have expanded their playbook each time. In 1970, they killed troubles that originated outside the banking system. In 1974, they auctioned off a failing bank. In 1984, they guaranteed uninsured deposits. After the 1987 stock market crash, they injected liquidity into the banking system. In 1998, they helped close a hedge fund. Even though each episode is different, the basic principles are the same. The Fed is willing to let a few dominoes fall. But in the end, it stops the chain reaction.
These various events are a dress rehearsal for the Fed’s extreme responses to the 2007-09 global financial crisis and the 2020 COVID-19 crisis. Both times it created a dizzying array of new credit facilities for struggling banks. It directs financing to difficult corners of the economy. It accepts a growing range of securities as collateral, including corporate bonds. It brought big companies out of business—most importantly Lehman Brothers. It withdrew most of its support as the market started functioning again.
Such a wide range of interventions prompts a rethinking of moral hazard. In the 1970s, the concern was over-regulation. Instead of making the financial system safer, policies such as caps on deposit rates have pushed activity toward shadow lenders. Regulators have gradually eased restrictions. But after the financial crisis, the pendulum swung back to regulation. Big banks must now hold more capital, limit trading and undergo regular stress tests. Strong support from the Federal Reserve has come with tighter restrictions.
Against this backdrop, the government’s response to SVB looks more like another breach in the wall than a radical new design. It’s not the first time uninsured savers have walked away unscathed in a financial disaster. It’s also not the first time the Fed has let multiple banks fail before introducing a credit program that could save similar companies.
hazard warning lights
Yet every breach in the wall also points to a growing Fed expansion. In one important respect, its aid has been far more generous than previous rescue operations. When extending emergency credit, it has generally been conservative in its collateral rules, using market prices to value securities that banks hand over in exchange for cash. Furthermore, it is designed to provide loans only to solvent companies. This time, however, the Fed accepted government bonds at face value even though their market value had fallen sharply. It’s amazing. If it had to forfeit its collateral, it could suffer a loss in present value. The plan could breathe life into banks that are insolvent by market capitalization.
The Fed has no intention of making its latest changes permanent. It has capped its special loans to just one year — long enough, officials hope, to avert a crisis. If they get their way, eventually calm will return, investors will shrug their shoulders, and banks will resume business without the need for Fed support. But if they don’t, more banks fail, and the Fed will hold underwater assets on its books, absorbing financial losses that would otherwise go to the market. Lender of last resort has the potential to turn into loss maker of first choice. ■
Read more from our economics column Free Exchange:
Emerging market central bank experiments risk reigniting inflation (March 9)
Case against Google hinges on antitrust ‘mistakes’ (March 2)
What would the perfect climate change lender look like? (February 23)
Plus: How the Free Exchange column got its name