Do we need a credit policy?
The last eighteen months have witnessed a revolution in financial regulation — if by that we mean a fundamental reconstruction, total change or turn round from the previous orthodoxy occurring in a relatively compressed time.
In particular, the sheer scale of recent policy interventions in the banking system is throwing up very uncomfortable questions about the government’s role in the economy, centered on its function as the ultimate re-insurer of risk and its function via the central bank as “lender of last resort” (LOLR) to the banking system.
The classic statement of LOLR operations set out in Walter Bagehot’s “Lombard Street” is to “lend freely, at penal rates, against good collateral”.
But in the aftermath of recent rescues, not much remains of the original doctrine. The Fed and other central banks are now lending freely, but to a wider range of institutions never envisaged before, against poor collateral, on increasingly generous terms, and providing support for solvency as well as liquidity.
Central banks and finance ministries are shouldering losses that properly belong to private shareholders and creditors. In the process they are protecting almost all depositors, and helping bail out shareholders. Walter Bagehot would be amazed at how far his doctrine has evolved.
The broadening of the lender of last resort guarantee was probably inevitable. But it makes explicit what was always implicit: in an integrated financial system the liabilities of the whole system are contingent liabilities of the central bank and ultimately the taxpayer.
In previous crises, the off-balance sheet liabilities of vehicles such as conduits have been consolidated back onto the balance sheet of the sponsoring commercial and investment banks. But in the current, system-wide crisis the liabilities of not just large banks but almost all financial institutions are being partially consolidated back onto the balance sheet of the central bank and the public treasury.
If system-wide liabilities are all, in some sense, contingent liabilities of the central bank and taxpayer, should the central bank and taxpayer regulate the quantity and type of these liabilities to limit the resulting fiscal and monetary risk? Is there a maximum size of banking sector and financial system that economies such as the Iceland, Switzerland or even the United Kingdom can safely maintain in relation to their national output?
A NEW CREDIT POLICY?
The attached paper (https://customers.reuters.com/d/graphics/CRDTPOLICY.pdf) sketches out some of these issues in more detail and tries to frame the relevant questions for both policymakers and financial institutions trying to pick through the rubble of the global banking system.
For the time being, there are more questions than answers. But what is clear is that the current crisis marks a fundamental break with past practice. Modest adjustments or evolutions of existing theory and policy will not be sufficient. The theory has broken.
The twin framework of fiscal and monetary policy (in place since the 1930s); the central banking doctrine of lender of last resort (in place since the late nineteenth and early twentieth centuries); and the inflation-targeting framework for monetary policy (in place since the 1990s) have all been weighed in the balance and found wanting.
Only a fundamental rethink from first principles can equip the system to face the challenges posed by the current crisis and prevent a recurrence.
In particular, central banks and financial regulators may need to develop a far more explicit policy to control the quantity and distribution of credit, separate from, but complementing existing monetary and fiscal policies.
Rather than interest rates, which manipulate the cost of funds, this “credit policy” may need to operate through direct quantitative controls, including reserve requirements, volume quotas, or deposit to lending ratios, perhaps imposed in a contra-cyclical or contra-trend manner designed to limit credit growth during expansions.
This would mark a sharp break with the free-market principles which have informed bank regulation and government policy over the last three decades, but no more sharp than the wholesale rescue of bank depositors, shareholders and borrowers with public funds over the last eighteen months.
It is time to consider whether the volume and composition of credit should be an explicit target for government policy, alongside output, inflation, employment and income distribution.
For previous columns by John Kemp, click here.