In his new book, Mervyn King, the former head of the Bank of England, tries to rewrite the role of central banks as lenders of last resort.  Specifically, he tries to create a formula that limits the amount a central bank will lend against the various assets a bank holds including the reserves it holds at the central bank.

Before dismissing his idea for the fatal flaw in it that even he admits to (central bankers don’t know how to value assets and if a financial crisis hits they will be pressured to lend against even the worse assets), let’s see if it has some merit.

Under his formula, banks and investors would know in advance how much funding a bank could receive from the central bank.  He would then restrict the total amount of deposits the bank could hold to being equal to this number.  Any assets the bank wants to hold above and beyond this number would have to be funded with a combination of equity and loss-absorbing unsecured debt.

Clearly, this would be a good way to get the banking system to fund itself with more equity.

In theory, this would also make bank failure possible and should minimize the risk of future taxpayer bailouts as the equity could be used to absorb losses.

However, as I discussed in Transparency Games, the discussion of the amount of equity on bank balance sheets is a red herring argument as there never is a need to bailout a bank.  With deposit guarantees, there is no reason a bank cannot continue to operate even when it has negative book capital levels (effectively, the deposit guarantee makes the taxpayers the bank’s silent equity partner).  The condition under which a bank would be allowed to continue is after writing down all its bad assets it can generate positive earnings before banker bonuses.  100% of these pre-banker earnings would then be used to rebuild its book capital.  Note, while book capital is being rebuilt, bankers would be paid no bonuses and shareholders would receive no dividends.  If after recognizing its losses a bank is unable to generate earnings before banker bonuses, it should be closed.

The focus on equity is also a red herring because when a financial crisis hits regulators will not force banks to recognize their losses.  Our current financial crisis was the latest confirmation of this reality.

Since regulators won’t require banks to recognize their losses when a financial crisis hits, they have rendered the whole idea of making bank failure possible or bank capital minimizing the need for taxpayer bailouts mute.

Mr. King’s proposal does bring up two interesting questions.  Should a central bank be restricted to lending only against good collateral?  Should central banks lend only if a bank has positive book capital?

Yes, central banks should be restricted to lending only against good collateral.  Transparency is needed so the market can independently value this collateral.  The central banks can then haircut this independent valuation in determining how much to lend against the collateral.

No, central banks should lend based on the availability of good collateral with no consideration for the level of book capital a bank has.  Recall with deposit guarantees the taxpayer is effectively the silent equity partner for a bank with a negative book capital level.