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How the State Controls the Banking System

AU.S.Second banking The fire may have died down, but cleanup efforts are continuing. Small and medium-sized banks have lost about $260 billion in deposits this year. The Fed continued to fill most of the gap, lending nearly $150 billion to banks through its emergency program. Next year the Fed must decide whether to extend them. As of May 1, the Federal Deposit Insurance Corporation (FDIC) would provide Congress with a menu of options on how to reform or expand support provided by regulators, which is currently capped at $250,000 per depositor. Many blame the restrictions (SVB).

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As happens after every banking panic, the safety net is being rebuilt. Regulators must therefore once again face a profound question: How far should the government reach into finance?

Banks are inherently unstable. They offer instantly redeemable deposits while holding long-term, illiquid assets such as mortgages and business loans. This mismatch means that even well-managed institutions are prone to misunderstandings and runs. The vulnerability of banks is matched by the severe consequences of their failures: runs are often contagious events that can lead to credit crunches and recessions.

Despite the danger banks pose, the government tolerates their existence. The shift in liquidity and maturity is thought to provide more credit and faster economic growth than would be possible under the alternative: a “narrow banking” system in which deposits are fully backed only by the safest assets.

Government props make the system more stable. But every piece of support needs to be done to stop bankers from exploiting taxpayers. Take, for example, the deposit insurance established in the United States under the Glass-Steagall Act after the Great Depression. Although President Franklin D. Roosevelt signed it into law and is often credited with its inventor, he actually tried to remove it from the bill, warning that it would “lead to lax bank management and carelessness on the part of bankers and depositors alike.” “. Roosevelt may have lost the argument; however, it is true that the more generous the deposit insurance, the less vigilant depositors will be and the greater the onus is on regulators to ensure that banks do not take undue risk.

Another line of support comes from central banks, which aim to stem self-fulfilling panics by acting as lenders of last resort.In a crisis, central bankers follow the dictum of Walter Bagehot, who is economist, lend freely with good collateral and penalty interest rates. This means determining what constitutes good collateral and how much “discount” (discount) to apply when valuing it. Exactly which assets the Fed or other central banks agree to lend against in a crisis will influence which assets banks choose to hold in normal times.

Central bankers have long recognized the dangers of providing too much support. In 2009, Sir Paul Tucker, then of the Bank of England, warned that central banks would become “secondary lenders” and that banks would not have to worry about the liquidity of their assets as long as they were deemed eligible collateral. However, central banks are becoming increasingly generous. The Fed’s latest mechanism is hardly Bagehot-esque, valuing long-dated securities at face value and imposing an interest penalty of just one-tenth of a percentage point, even when the market is deeply discounting.

The logical thing to do to expand the banking industry’s safety net is to create rules to ensure that the wider network is not exploited. After the 2007-09 global financial crisis, regulators viewed long-term government bonds as a safe and liquid asset they believed would be a source of liquidity that bankers could draw on before turning to the central bank when the next crisis hits.Now that the risks to long-dated assets have become all too apparent from rising interest rates, the Fed and FDIC After all, with a jar. Regulators could respond by redefining the highest-quality liquid assets as short-term bonds issued by the most creditworthy sovereign borrowers. Doing so, however, would be a step towards narrow banking where every deposit is backed by such assets.

This trade-off between the safety of the banking system and the power of regulators used to be blurred. Some central banks are deliberately ambiguous about what kind of collateral they will accept in an attempt to keep banks on their toes. But new technologies appear to be forcing the government’s role into the open.Many blame mobile banking apps and social media for faster operations SVB. If a run is more likely now, so is emergency central bank lending, making collateral policy even more important.

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Another looming change is the issuance of central bank digital currencies, which could offer the public an alternative to bank deposits. In recent years, economists have worried that such currencies risk becoming de facto parochial banks, draining legacy systems. But some argue that if the public converts their deposits into a central bank digital currency, banks will do just fine, as long as the central bank steps in to make up for lost funds. “issued [such currencies] “This only makes explicit the central bank’s implicit lender-of-last-resort guarantee,” wrote Markus Brunnermeier and Dirk Niepelt in 2019. SVBas deposits flow from small banks to money market funds, which can park cash at the Fed, which in turn lends to banks.

The prospect of banks being de facto government-funded should alarm anyone who values ​​the role of the private sector in risk judgment. However, the distinction between deposit financing underwritten by multiple layers of the state and funding provided directly by the state itself is increasingly difficult to distinguish. A more defined role for the government in the banking system could be the logical end point of a path that regulators have been on for some time.

Read more from our economics column Free Exchange:
Why Economics Don’t Know Business (April 4)
China now unlikely to be a safe haven (March 30)
US banks lose hundreds of billions of dollars (March 21)

Plus: How the Free Exchange column got its name

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