Failures of confidence building – a question November 11, 2013 at 10:00 am

One of the roles of a financial stability authority – the central bank perhaps – is to reassure the market in crisis that an institution under stress is indeed solvent albeit not liquid. They do this in part by words and in part by deeds: by lending. The communication of solvency to the market is so important the most lenders of last resort are required to separate in form lending to the solvent-but-illiquid from capital injections or other solvency support. This role of an impartial arbiter of solvency is important, and indeed existed in the US before the FED. As Bernanke describes in a recent speech during the panic of 1907

the New York Clearinghouse, a private consortium of banks, reviewed the books of the banks under pressure, declared them solvent, and offered conditional support

I have a question. Can those readers more knowledgeable of the history of financial crises that I, please give me any examples of where this hasn’t worked? That is, where a third party has during a crisis assessed the solvency of stressed institutions, declared them to be solvent, but the market has not believed the statement and a panic was not prevented? I am guessing that the provision of liquidity helps, in that the liquidity may put stress off for long enough that the institution can recover. Equally, sometimes words have been enough. When weren’t they?

6 Responses to “Failures of confidence building – a question”

  1. Wouldn’t it be more realistic to ask when the talking cure *has* worked? It didn’t work in 1907 – even after Morgan strong-armed the industry into lending on October 23rd, and the treasury secretary made his deposits on the 24th, the panics continued. Another round of lending to all the trusts was required on the weekend of November 2nd; by that point Morgan was willing to personally support only TC&I and Moore and Schley.

    The point is that 1) talking wasn’t enough, actual lending was required, and 2) that was difficult because money was in short supply. The banks had to invent a scrip – “loan certificates” – to settle transactions between themselves.

    Turning to modern times, in 2008/9 the broker-dealers appear to have been insolvent in aggregate. That would preclude restoring confidence by a self-insurance scheme.

  2. In Bagehot’s opinion in the event that lender-of-last-resort operations failed to restore confidence, the central bank itself would fail. (He was, of course, writing in the gold standard era.)

    “It may be said that the reserve in the Banking Department [of the Bank of England] will not be enough for all such loans. If that be so, the Banking Department must fail. But lending is, nevertheless, its best expedient. This is the method of making its money go the farthest, and of enabling it to get through the panic if anything will so enable it. Making no loans as we have seen will ruin it; making large loans and stopping, as we have also seen, will ruin it. The only safe plan for the Bank is the brave plan, to lend in a panic on every kind of current security, or every sort on which money is ordinarily and usually lent. This policy may not save the Bank [of England]; but if it do not, nothing will save it.”

  3. Words can be enough but that depends on who is speaking them. I’m pretty sure J.P. Morgan’s assurances were more trusted and effective than those of the New York Clearinghouse during the Panic of 1907.

    Bernanke is trying to claim an institutional legacy for the Fed that isn’t really there. He heads an institution that came into being because J.P. Morgan died and left a massive authority vacuum. The Fed has been THE financial stability authority much longer than J.P. was and it has been quite adept at times but trust and faith in the Fed is not infinite; perpetual QE is making a lot of market participants nervous.

  4. Northern Rock? Bradford & Bingley?

    “The FSA reiterates that it judges Northern Rock to be solvent and that savers can continue to deposit and withdraw funds.”

  5. Thank you all – most helpful.

    GY: I particularly like the Northern Rock example: it shows that even a small gap in deposit protection makes a big difference. Faced with losing 10% of their depos if FSA was wrong, retail depositors ran.

    Phil – clearly I need to read the 1907 history more carefully. Re the B/Ds in 2008, my personal view is that they (1) doubted each other’s solvency, even though they were mostly wrong to do so and (2) knew each other’s illiquidity. Self insurance would have worked had they had access to the FED window, which they (mostly – there are minor counterexamples of small entities within the B/D groups that were banks) didn’t until after Lehman.

  6. GY: I particularly like the Northern Rock example: it shows that even a small gap in deposit protection makes a big difference. Faced with losing 10% of their depos if FSA was wrong, retail depositors ran.

    I’m not even sure it was the gap. Given how the UK guarantee scheme worked, even the threat of having your access to guaranteed deposits frozen for a period of time would have been enough for many people.