A century ago we had banks. They created systemic risk. We decided to regulate them in order to limit the systemic risk they could create. That was wise.
Now we have non-banks. They create systemic risk…
RGE Monitor: Since the onset of the liquidity and credit crunch last summer this column has been arguing that monetary policy would be impotent to address such a crunch because, in part, of the existence of a non-bank “shadow financial system”… conduits, SIVs, investment banks/broker dealers, money market funds, hedge funds and other non bank financial institutions… highly leveraged and borrow short and in liquid ways and invest or lend long and in illiquid ways… subject not only to credit and market risk but also to rollover or liquidity risk….
Unlike banks this shadow financial system does not have access to the lender of last resort support of the central bank as these are not depository institutions regulated by the central banks. What we are now observing… is a generalized liquidity run on this shadow financial system.
The response of the Fed to this run has been radical… lender of last resort support to non bank financial institutions… $200 bn term facility allows primary dealers… to swap their toxic mortgage backed securities for US Treasuries… Bear Stearns… JPMorgan… now the Fed is allowing primary dealers to access the Fed discount window at the same terms as banks.
This is the most radical change and expansions of Fed powers and functions since the Great Depression: essentially the Fed now can lend unlimited amounts to non bank highly leveraged institutions that it does not regulate…. [I]t is treating this crisis… as if it was purely a liquidity crisis. By lending massive amounts to potentially insolvent institutions that it does not supervise or regulate and that may be insolvent the Fed is taking serious financial risks and seriously exacerbate moral hazard distortions….
But this is not just a liquidity crisis; it is rather a credit and insolvency crisis. And it is not the job of the Fed to bail out insolvent non bank financial institutions. If a bail out should occur this is a fiscal policy action that should be decided by Congress after the relevant equity holders have been wiped out and senior management fired without golden parachutes and huge severance packages…