When I studied monetary economics and banking in college and graduate school, I was taught that a basic function of a central bank was to act as the lender of last resort when the market ceased to finance the banking system.
Since the crisis of 2008, we have seen criticism of the Troubled Asset Relief Program and the Federal Reserve for having provided liquidity to the banking system and protecting “too big to fail” or “too important to fail” institutions. Now in the Dodd-Frank Act we have the concept of “orderly liquidation” so that no institution is too anything to fail.
We also see, in commentary about the European sovereign crisis, the criticism that the authorities are protecting the banks rather than having creditors contribute their pound of flesh.
Well, I cannot think of a bank equity investor that has not contributed some serious loss of value to the restoration of the banking system’s stability. Preferred shareholders have also contributed in some situations. And where institutions were allowed to fail, bondholders have contributed.
So when I see it suggested that somehow more market discipline needs to be brought to bear, so that management teams do not believe their companies are “too big to fail,” I think two things.
First, doesn’t the loss of equity value during this period mean that equity investors are going to be more mindful of what institutions and their regulators are up to?
Second, not every institution should fail when a crisis causes liquidity to dry up. Central banks are supposed to fulfill the lender of last resort function on a systemic basis because the allocation of credit is a systemic issue.
Investors should not be penalized for providing such liquidity, unless there is insufficient capital to bear the losses and incremental capital from private investors cannot be found. Only then will existing equity holders pay, as they should, through either dilution or an orderly wind down. This is what happened to Lehman Brothers, although the markets and the initial stages of the wind down were far from orderly due to the systemic stress at that time.
Thankfully, we do not know how far the economy would have fallen if liquidity had not been provided. We do know that the government has made a lot of money, at the expense of bank shareholders, by providing that liquidity and acting as the Lender of Last Resort.
However, many commentators ignore the Lender of Last Resort function and think any bank that gets central bank liquidity is a failed bank. This is far from accurate and I am surprised that economists and regulators have not commented on this.
Thomas J. White is a former executive vice president and head of credit at Dwight Asset Management and has held senior portfolio and risk management positions at MetLife and J.P. Morgan & Co.