It can only be attributable to human error September 18, 2013 at 4:48 pm

Dave: Hello, Hal. Do you read me, Hal?

Hal: Affirmative, Dave. I read you.

Dave: Open the central bank window, Hal.

Hal: I’m sorry, Dave. I’m afraid I can’t do that.

This classic exchange, or at least my version of it, came to mind as I listened to an excellent talk by Hal Scott yesterday. Scott’s paper on Interconnectedness and Contagion is justly well-known. One of its theses is that contagion between financial institutions in a crisis might well be inevitable; that capital cannot reasonably be raised to levels where contagion cannot occur; and that liquidity risk similarly cannot be reduced to the point where runs on some class of financial system liabilities are impossible. Scott then argues that if this is true, then the FED has been shot in the foot by Dodd Frank’s restrictions* on who it can lend to in extremis. The lender of last resort function is the most important tool in killing contagion, Scott suggests, and as you don’t know a priori which class of institutions you will have to lend to, restricting yourself to banks is counterproductive. Resolution is a useful tool in dealing with the consequences of contagion, but wouldn’t it be better to have a wide spectrum antibiotic which can deal with the infection rather than an efficient funeral and burial service?

Perhaps, then, one of Hal’s best lines should really be spoken by the architects of the Dodd Frank restrictions on who can access the FED window:

I know I’ve made some very poor decisions recently, but I can give you my complete assurance that my work will be back to normal. I’ve still got the greatest enthusiasm and confidence in the mission. And I want to help you.

*Section 1101 of the Dodd Frank Act, Federal Reserve Act Amendments on Emergency Lending Authority, since you ask. And Section 716 restrictions on lending to swap entities for that matter.

5 Responses to “It can only be attributable to human error”

  1. Spot on. Next time there’s no net.

  2. This human error inspired version also came to mind yesterday:

    Dave: It’s time to wind down QE now, Hal.

    Hal: I’m sorry, Dave. I’m afraid I can’t do that.

  3. Well, maybe. But don’t forget that central banks have since their origins been first threatening shadow banks with lack of support and finally allowing shadow banks to fail. If you read Bagehot carefully, it appears that the 1866 Overend and Gurney (a bill broker or shadow bank) crisis, where the Bank of England deliberately allowed a huge shadow bank to fail, shaking the financial system to its core, is what motivated him to write Lombard Street. If anything the crisis seems to have stablized the late 19th c. British banking system. Part of a central bankers job is regularly allowing portions of the shadow banking system to be wiped out — in order to protect the long-term health of the core banking system.

    In short, while your concerns merit consideration, in the modern climate where the central bankers don’t seem to have the backbone to face off with the shadow banking system when it threatens instability (e.g. why was Citi allowed to bail out its SIVs), laws like Dodd-Frank may be the best we can do.

  4. Thanks, Carolyn. I agree completely that the flip side of wide potential access to the LOLR is strict policing of actual usage, including both a high bar for any use and a high rate when LOLR facilities are used. Legislative inflexibility – while well motivated – isn’t the right answer here, though. Perhaps the FSOC should have to give a supermajority vote on non-bank access to the FED, with papers released publically after a suitable delay, or something like that?

  5. Agreed that other mechanisms are possible — maybe even better. Rather than a supermajority I would prefer giving the head of each bank regulatory agency and the Treasury secretary veto power over any such decision.