When is less more? Bank arrangements for liquidity vs central bank support
Summary
Focus
Banking crises stem from liquidity transformation, where banks borrow short-term to invest in long-term, illiquid assets. When liquidity shortages occur, banks are forced to sell assets at fire-sale prices, leading to significant losses. In such scenarios, access to additional funding can help mitigate these losses. A key question is what form this funding should take: private insurance arrangements like contingent equity, public liquidity support through central bank bailouts or high-interest loans, or pre-arranged liquidity facilities with central banks? This paper analyses these options, examining their effectiveness, costs, and interactions to determine the most efficient approach to addressing liquidity crises.
Contribution
Over the past century, central bank interventions in response to banking crises have grown significantly, alongside the introduction of public insurance schemes like deposit insurance. Since World War II, central bank responses to financial crises have become "close to systematic." Yet, puzzlingly, despite the presence of ex-ante public backstops and large-scale public liquidity provision ex post, major banking crises still occur worldwide, even in advanced economies with strong regulatory frameworks. Why?
Findings
Private insurance mechanisms, such as contingent capital, can mitigate overinvestment by banks and lead to socially optimal outcomes in the absence of public interventions. However, the prospect of central bank liquidity support, particularly when underpriced, tends to crowd out private insurance markets and induce overinvestment by banks. This moral hazard, in turn, exacerbates financial instability. Appropriately priced and pre-committed central bank interventions can improve welfare, but achieving the correct pricing is challenging due to political and practical constraints.
Abstract
Theory suggests that in the face of fire-sale externalities, banks have incentives to overinvest in order to issue cheap money-like deposit liabilities. The existence of a private market for insurance such as contingent capital can eliminate the overinvestment incentives, leading to efficient outcomes. However, it does not eliminate fire sales. A central bank that can infuse liquidity cheaply may be motivated to intervene in the face of fire sales. If so, it can crowd out the private market and, if liquidity intervention is not priced at higher-than-breakeven rates, induce overinvestment once again. We examine various forms of public intervention to identify the least distortionary ones. Our analysis helps understand the historical prevalence of private insurance in the era preceding central banks and deposit insurance, its subsequent disappearance, as well as the continuing incidence of banking crises and speculative excesses.
JEL classification: E58, G01, G21
Keywords: banking crises, financial stability policies