A bipartisan bill has been introduced by Senators Vitter and Warren that would change how the Fed could implement its lender of last resort function.  Specifically, the bill would prevent the Fed from lending to insolvent financial institutions and would require the Fed to charge a premium to those financial institutions it does lend to.  These proposals have stirred a surprising amount of pushback.

The impetus for this legislation is the simple observation that the Fed appeared to be the personal piggybank for the bankers during the financial crisis.  As reported by Bloomberg, the pricing on the Fed’s loans during the crisis resulted in a $13 billion boost to the banks’ earnings.  A significant amount of this increase in earnings courtesy of the taxpayers was subsequently paid out as bonuses to the bankers.

In Transparency Games, I discuss how deposit guarantees dramatically changed the lender of last resort role.  When originally put forth by Walter Bagehot, central banks were only suppose to act as a lender of last resort for solvent financial institutions.  The bipartisan bill would make this a requirement.

However, with the introduction of deposit insurance in the 1930s, it became possible to lend to insolvent financial institutions too.  Why?  Deposit insurance effectively makes the taxpayers an insolvent bank’s silent equity partner.

Being able to lend to insolvent financial institutions helps to both maintain and restore financial stability.  Since the insolvent bank can access funds from the central bank, it is not forced to sell its assets in a fire-sale.  This helps to improve financial stability.  In addition, with access to liquidity, an insolvent firm might be able to earn its way back to solvency.

In Transparency Games, I say deposit insurance changed Bagehot’s lender of last resort role to central banks are suppose to act as a lender of last resort for viable financial institutions.  A viable financial institution is one where after recognizing its losses it is still able to generate earnings (i.e., its income is greater than its expenses).  If a financial institution isn’t viable, it should be shut down.

Bagehot also argued that central banks acting as a lender of last resort should lend at a penalty rate of interest.  Again, the bipartisan bill would make this a requirement.

While I agree there should be a penalty rate of interest, I think this penalty needs to be set so central bank lending is actually a source of liquidity and therefore supports financial stability.  For example, the penalty rate of interest could be 1% over a bank’s existing cost of funds for the liabilities on its books.  This penalty rate is high enough so bankers don’t profit from tapping the central bank, but it is low enough so bankers would rather access loans from the central banks than engage in the fire-sale of their assets.

Ben Bernanke weighed in against the bipartisan bill.  On his blog, he offered up the following defense:

The problem is what economists call the stigma of borrowing from the central bank. Imagine a financial institution that is facing a run but has good assets usable as collateral for a central bank loan. If all goes well, it will borrow, replacing the funding lost to the run; when the panic subsides, it can repay. However, if the financial institution believes that its borrowing from the central bank will become publicly known, it will be concerned about the inferences that its private-sector counterparties will draw. It may worry, for example, that its providers of funding will conclude that the firm is in danger of failing, and, consequently, that they will pull their funding even more quickly. Then borrowing from the central bank will be self-defeating, and firms facing runs will do all they can to avoid it.This is the stigma problem, and it affects everyone, not just the potential borrower. If financial institutions and other market participants are unwilling to borrow from the central bank, then the central bank will be unable to put into the system the liquidity necessary to stop the panic. Instead of borrowing, financial firms will hoard cash, cut back credit, refuse to make markets, and dump assets for what they can get, forcing down asset prices and putting financial pressure on other firms. The whole economy will feel the effects, not just the financial sector.

The stigma problem is self-serving drivel dreamt up by central bankers/economists protecting the opacity of the banks.

Imagine banks had to provide transparency and disclose their current exposure details.  Market participants would then know if a bank was solvent or insolvent,  In addition, market participants would know if a bank was viable or not viable.  There is absolutely no reason to think market participants would run to pull out their funds from a viable, insolvent bank.  They know a central bank would provide liquidity support to this bank and the financial regulators would not close this bank.

However, banks don’t provide transparency.  As a result, banks are subject to runs by unsecured creditors.  After all, these creditors have no way of determining if their investment is safe or not.  As a result, they are better off panicking and getting their investment out as soon as possible.  In 1984, this happened with Continental Illinois when wholesale funders ran to get their money back.  It also happened at the beginning of the recent financial crisis.

The stigma problem is very real, with many historical illustrations. When the BBC announced in 2007 that the British lender Northern Rock had received a loan from the Bank of England, for example, a severe run on the lender began almost immediately. Ultimately, the government had to take the firm over.

It was not stigma that was the problem for Northern Rock, but rather the fact it was not viable.

The Warren-Vitter legislation would create an insuperable stigma problem. (It has other drawbacks as well, but my focus here is on stigma.) First, the requirement that solvency analyses be released immediately (or quickly) would publicly identify any potential borrowers. No borrower would allow itself to be so identified, for fear of the inferences that might be drawn about its financial health.

Notice how this whole line of argument goes away if banks are required to provide transparency and disclose their current exposure details.  All market participants would know exactly why the bank was borrowing from the central bank.  Market participants wouldn’t have to draw inferences about the financial health of the bank.  Rather, they could do their own due diligence and understand the current financial health of the bank.

Second, the five percentage point penalty rate requirement would remove any doubt that those borrowing from the central bank had no access to other sources of funding, further worsening the stigma problem. (A penalty rate was not a problem in Bagehot’s era, because, unlike today, all lending by the central bank was strictly confidential.)

As discussed previously, I think the penalty rate should be linked to the bank’s existing cost of funds so the central bank can truly be a source of liquidity during times of financial stress.