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?