It is widely accepted that in times of financial crisis, central banks should follow Bagehot’s rule which can be summarised as: “Lend without limit, to solvent firms, against good collateral, at ‘high rates’.” However, as I noted a few months ago, the Fed and the ECB seem to be following quite a different rule which is best summarised as: “Lend freely even on junk collateral at ‘low rates’.”

The Fed’s response to allegations that they went beyond their mandate for liquidity provision is instructive. In the Fed’s eyes, the absence of credit losses signifies that the collateral was sound and the fact that nearly all the programs have now closed illustrates that the rate charged was clearly at a premium to ‘normal rates’. This argument gives the Fed a significant amount of flexibility as a rate that is at a premium to ‘normal rates’ can still quite easily be a bargain when offered in times of crisis. Nevertheless, the Fed can point to the absence of losses and claim that it only provided liquidity support. The absence of losses is also used to refute the claim that these programs create moral hazard. However, both these arguments ignore the fact that the creditworthiness of assets and the solvency of the banking system cannot be separated from the central banks’ actions during a crisis. As the Fed’s Brian Madigan notes: “In a crisis, the solvency of firms may be uncertain and even dependent on central bank actions.”

However, the Fed’s response does highlight just how important it is to any central bank that it avoid losses on its liquidity programs - not so much to avoid moral hazard but out of simple self-interest. If a central bank exposes itself to significant losses, it runs a significant reputational and political risk. Given the criticism that central banks receive even for programs which do not lose any money, it is quite conceivable that significant losses may even lead to a reduction in their independent powers. Whether or not these losses have any ‘real’ relevance in a fiat-currency economic system, they are undoubtedly relevant in a political context. The interaction of the central bank’s desire to avoid losses and its ability to influence asset prices and bank solvency has some important implications for its liquidity policy choices - In a nutshell, the central bank strongly prefers to backstop assets whose valuation is largely dependent on “macro” systemic risks. Also, when it embarks upon a program of liquidity provision it will either limit itself to extremely high-quality assets or it will backstop the entire spectrum of risky assets from high-grade to junk. It will not choose an intermediate threshold for its intervention.

The first point is easily explained - by choosing to backstop ‘macro’ assets whose prices and performance are strongly reflexive with respect to credit availability, the program minimises the probability of loss. For example, a decision to backstop housing loans has a significant impact on loan-flow and the ‘real’ housing market. A decision to backstop small-business loans on the other hand can only have a limited impact on the realised business outcomes experienced by small businesses given the idiosyncratic risk inherent in them. The negatively skewed payoff profile of such loans combined with their largely ‘macro’ risk profile makes them the ideal candidates for such programs - such assets are exposed to a tail risk of significant losses in the event of macroeconomic distress, which is the exact scenario that central banks are mandated to mitigate against. The coincidence of such distress with deflationary forces enables central banks to eliminate losses on these assets without risking any overshooting of its inflation mandate. This also explains why central banks are reluctant to explicitly backstop equities even at the index level - the less skewed risk profile of equities means that the risk of losses is impossible to reduce to an acceptable level.

The second point is less obvious - If the central bank can restrict itself to backstopping just extremely low-risk bonds and loans, it will do so. But in most crises, this is rarely enough. At the very least, the central bank is required to backstop average-quality assets which is where the impact of uncertainty is greatest and the line between solvency and liquidity risk is blurriest. But this is not the strategy that minimises the risk of losses to the central bank. The impact on the system from the contagious ripple effects of the losses incurred on the junk assets can cause moderate losses on higher-quality assets. This incentivises the Fed to go far beyond the level of commitment that may be optimal for the economy and backstop almost the entire sphere of “macro” assets even if many of them are junk. In other words, it is precisely the desire of the Fed to avoid any losses that incentivised it to expand the scope of its liquidity programs to as large a scale and scope as it did during the crisis.

These preferences of the central bank have implications for the portfolios that banks will choose to hold - banks will prefer ‘macro’ assets without excessive micro risk as these assets are more likely to be backstopped by the central bank during the crisis. This biases bank portfolios and lending towards large corporations, housing etc. and against small business loans and other idiosyncratic risks. The system also becomes less diverse and more highly correlated. The problem of homogeneity and inordinately high correlation is baked into the structural logic of a stabilised financial system. Such a system also carries a higher risk of asset price bubbles - it may be more ‘rational’ for a bank to hold an overpriced ‘macro’ asset and follow the herd than to invest in an underpriced ‘micro’ asset. Douglas Diamond and Raghuram Rajan identified the damaging effects of the implicit commitment by central banks to reduce rates when liquidity is at a premium: “If the authorities are expected to reduce interest rates when liquidity is at a premium, borrowers will take on more short-term leverage or invest in more illiquid projects, thus bringing about the very states where intervention is needed, even if they would not do so in the absence of intervention.” Similarly, the incentives of the central bank to avoid losses at all costs perversely end up making the financial system less diverse and fragile.

When viewed under this logic, the ECB’s actions also start to make sense and criticisms of its lack of courage seem misguided. In terms of liquidity support extended, the ECB has been at least as aggressive as the Fed. in fact, in terms of the risk of losses that it has chosen to bear, the ECB has been far more aggressive. Despite the losses it faces on its Greek debt holdings,it has nearly doubled its peripheral government bond holdings in recent times. This is despite the fact that the ECB runs a significant risk of losses on its government bond holdings in the absence of massive fiscal transfers from the core to the periphery, a policy for which there is little public or political appetite.

The ECB’s desire for the EFSF to take over the task of backstopping the periphery simply highlights the reality that the task is more fiscal than monetary in nature. Relying on the ECB to pick up the slack rather than constructing the fiscal solution also exacerbates the democratic deficit that is crippling the Eurozone. The ECB is not the first central bank that has pleaded to be relieved of duties that belong to the fiscal domain. Various Fed officials have made the same point regarding the Fed’s credit policies - drawing on Marvin Goodfriend’s research, Charles Plosser summarises this view as follows: “the Fed and the Treasury should agree that the Treasury will take the non-Treasury assets and non-discount window loans from the Fed’s balance sheet in exchange for Treasury securities. Such a new ”accord“ would transfer funding for these special credit programs to the Treasury — which would issue Treasury securities to fund the transfer — thus ensuring that these extraordinary credit policies are under the oversight of the fiscal authority, where such policies rightfully belong.” Of course, the incentives of the government are to preserve the status quo - what better than to let the central bank do the dirty work as well as reserving the right to criticise it for doing so!

This highlights a point that often gets lost in the monetary vs fiscal policy debate. Much of what has been implemented as monetary policy in recent times is not only not ‘neutral’ but is regressive in its distributional effects. In the current paradigm of central bank policy during crises, systemic fragility and inequality is an inescapable structural problem. On the other hand, it is perfectly possible to construct a fiscal policy that is close to neutral e.g. Steve Waldman’s excellent idea of simple direct transfers to individuals.


10 Tuesday AM Reads | The Big Picture

[...] • Bagehot’s Rule, Central Bank Incentives and Macroeconomic Resilience (Macroeconomic Resilience) [...]

David Pearson

Much of the current monetary debate "safely" ignores Bagehot's rule. The idea is that private sector portfolios exhibit, "excess liquidity demand" that retards nominal growth. Therefore, the Fed should buy any illiquid asset and replace it with a liquid one until this excess demand is met. This thesis gives the Fed carte blanche to transform literally any asset purchase from the "fiscal" into the "monetary". Obviously, this has implications for the size of the "democratic deficit", among other potential consequences. How would you respond to the above view?


David - There's a minority of central bankers who appreciate the problems with this monetary overreach (Goodfriend, Plosser, Lacker) but the academic monetarist argument ignores all these uncomfortable details. And as I said, the government and special interests prefers this backdoor fiscal action. I don't buy the "excess liquidity demand" argument - most of the demand simply comes from the realisation that much of what was imagined to be "safe" has turned out to be junk. "Shadow" money supply has therefore contracted which has been replaced by an expansion in "conventional" money. So it's easy for the Fed to prevent deflation but it's much harder for it to create any significant amount of inflation, especially in a controllable manner. They can create asset price inflation, fuel a few bubbles but most of their actions are just going to end up as excess reserves.


Ashwin Excellent points about liquidity/solvency, the Fed's incentives to buck-stop a wide range of assets and the resultant incentive to hold macro assets, even if 'overpriced'. There is an obvious counterpoint though - if everyone does the same thing, the rate of return on these assets will decrease and eventually enough investors will diversify. In fact, under almost every macro-economic policy decision, there are two types of rational behaviour : there is the first order 'equilibriating' behaviour of the kind that I mention, and there is the second order destabilizing (or rather, 'de-resiliating' behaviour) that you frequently write about. The question is - will the system blow up before the near-equilibrium situation prevails. That question seems rather difficult to answer analytically. But it may be simpler to enforce in practice : leverage caps. In general, as crude as a tool as they are, leverage caps seem to be possibly the best way to ensure that policy incentives operate in the 'corridor' of first order effects.


Ritwik - Thanks. By saying that the assets are overpriced, I'm being a little sloppy given the Fed's abilities to turn an overpriced macro asset into a fairly priced one via the backstop and monetary easing,reducing real rates etc. I forgot to mention it in the post but the key dynamic that makes bubbles likelier is that it makes shorting any of these markets a much riskier proposition. I tend to prefer simple regulations like the leverage caps that you mention. But I'm afraid that even these will be circumvented by financial innovation sooner or later.

David Pearson

Ashwin, Agreed. Much of the "excess liquidity demand" was just an increase in idiosyncratic risk (of shadow bank liabilities). This is an intermediation problem: we lost the shadow banks' ability to perform liquidity and maturity transformation. Nothing has stepped in to fill the void since large banks are "zombified" in an attempt to favor existing shareholders.


Another great article ashwin. However you don't mention deposit insurance. If the CB is biased to avoid losses on its holdings, the treasury is even more biased IMO to avoid a situation which triggers un-payable FDIC claims. Were this event to occur, it could only be met using money funding from the CB. So overall it would seem to be the case that the interests of both the CB and the treasury converge so as to almost guarantee the behaviour and policy you have written about. However this convergence of interest IMO calls into question the notion of an independent central bank regardless of its profit/loss position.


I agree that I left out the deposit insurance angle. Your argument is particularly relevant for TBTF banks.


So a better way for central banks to get dormant excess reserves moving, would be to reduce the FDIC limit...

Macroeconomic Stabilisation and Financialisation in The Real Economy at Macroeconomic Resilience

[...] and weeded out – this loss of diversity is exacerbated by banks’ adaptation to the intervention strategies preferred by central banks in order to minimise their losses. And most critically, the suppression of disturbances increases [...]

Bernanke, die Fed und das Ende der unorthodoxen Geldpolitik | My Blog

[...] [65] [...]