Thursday, February 5, 2009

Bank Run Prevention 101, And The Recent Band-Aiding By the Government

A few days ago the Fed had to (was forced to) postpone the expiration date of virtually all liquidity facilities designed to stop and prevent the mother of all bank runs, which followed the Reserve Fund's breaking the buck after Lehman's collapse. As few people pointed out, the removal of these contingencies would likely have brought the liquidity crisis back with a vicious bang. Furthermore, it reminds us once again of the truly bad shape the liquidity component of the U.S. economy is right now (in addition to all the other crutches the government is using to make sure the financial system does not collapse).

This chart summarizes all the liquidity facilities currently in use as well as which ones had their maturity dates extended (virtually all).

A reminder of last September's events: When the Reserve fund "broke the buck", investors withdrew several hundred billion from other prime money market funds. As prime funds invest in ST instruments such as commercial paper (CP), that lead to partial withdrawal of a key provider of ST funding for corporations, and the CP market ended up having to borrow overnight at much higher rates. The Fed intervened by setting up the CP Funding Facility (CPFF) which buys 3 months CP from tier 1 issuers, filling the gap left by the collapse in prime fund assets. The recent $100 billion decline in outstandings under the CPFF implies issuers are weaning off the facility and using the private CP market again, as well as leeching off other programs such as TLGP government guaranteed term debt issuance.

So whereas recent trends were a somewhat positive data point, the maturity extension raises more fundamental questions about what the Fed may be seeing (that others can't or are not allowed to see).

A prophetic policy paper written by the Cleveland Fed in June 2007, before the bubble had burst, entitled "On the Resolution of Financial Crises, The Swedish Experience" provides good philosophical insight into what is currently going on in the market. To nobody's surprise the government is doing all it can (whether in the form of the above mentioned liquidity guarantee extensions or otherwise) to mitigate the shock to the system in the near-term; however, the long-term impact gets exponentially worse the more the administration cushions the blow today and tomorrow. The fact that our children's lives will be adversely impacted so that we can purchase on credit for a few more months, live in an upside down mortgaged house, and general hang on to the last traces of an uber-leveraged lifestyle which will become extinct soon enough, is representative of a phenomenal form of egotism, which in my opinion is much more worthy of a populist crusade than Al Gore's attempt to turn everyone's attention to global warming (although that is also a noble cause).

The third trait of a successful resolution strategy is the maintenance of market discipline. Without it, the stage is set for future crises. For example, extending blanket guarantees during a crisis weakens the market discipline exerted by uninsured creditors in the postcrisis period. Uninsured depositors and nondeposit creditors have strong incentives to monitor and discipline financial institutions by raising their cost of funding when their risk increases. At some point, as the probability of default increases, uninsured claimants will threaten to liquidate their claims. If market discipline is to be effective, these investors must be credibly exposed to loss; that is, they must suffer the consequences of ignoring or failing to detect signs of trouble. An explicit blanket guarantee of all the liabilities of problem institutions in the throes of a crisis reduces the credibility of claims that defacto guarantees will not be extended in future bank failures.

Similar incentive problems arise when regulators and policymakers respond to the crisis by bailing out banks’ creditors through a policy of capital forbearance and unlimited liquidity support. Although bailouts tend to alleviate pressures on the financial system, forbearance and unlimited liquidity support allow uninsured investors to take their money out of the bank, shielding them from loss and reducing their incentive to monitor in the future. In essence, capital forbearance and unlimited liquidity support provide an implicit blanket guarantee and serve as a taxpayer-funded rescue package for sophisticated investors who purposely took on risk and were compensated for bearing it.

Sphere: Related Content
Print this post


James said...

Really disturbing. Everyday I wonder why the government is forcing people to take risks the shouldnt and dont understand. Eventually the fed is going to crush even more precious savings that the country desperately needs when this whole thing collapses agian.

RW said...

Tyler....where does the Fed publish data on $ outstanding under each of the emergency facilities?

Tyler Durden said...

Fed H.4.1 report