Kathryn Judge

Columbia University; ECGI

Guarantor of Last Resort

10/06/2020

The optimal response to a financial crisis entails addressing two, often conflicting, demands: stopping the panic and starting the clock.

When short-term depositors flee, banks can be forced to sell assets at fire-sale prices, causing credit to contract and real economic activity to decline. To reduce these adverse spillover effects, policymakers routinely intervene to stop systemic runs. All too often, however, policymakers deploy stopgap measures that allow the underlying problems to fester. To promote long-term economic health, they must also ferret out the underlying problems and allocate the losses that cannot be avoided. A well-designed guarantor of last resort can help address these conflicting demands. Just-in-time guarantees keep private capital in the system, providing policymakers the time that they need to develop a viable plan to address deficiencies. A strict time limit on those guarantees ensures that policymakers and market participants remain motivated to devise such a plan, avoiding the alternative pitfall of excessive forbearance.

I. INTRODUCTION

"In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them."

Walter Bagehot

 

How best to fight financial panics is a matter of ongoing debate. On the one hand, concerns about moral hazard abound. When bank depositors and other short-term creditors anticipate government protection, they have little incentive to undertake costly monitoring. This reduces market discipline and can lead to excessive risk taking. On the other hand, the government cannot credibly commit to a no-bailout policy. As Walter Bagehot recognized nearly 150 years ago, once panic sets in, the resulting harm extends far beyond the fleeing creditors and the institutions issuing their claims. Panics can lead to market dysfunction, credit contraction, and recession. The Great Depression vividly illustrates how ordinary Americans suffer when the government tries to force bankers to stew in their own juices.

Read more