I. The Credit Crunch of 2007-2009
The global credit crunch induced by the subprime mortgage crisis in the United States, in the second half of 2007, engendered a tectonic and paradigmatic shift in the way central banks perceive themselves and their role in the banking and financial systems.
On December 12, 2007, America's Federal Reserve, the Bank of England, the European Central Bank (ECB), the Bank of Canada and the Swiss National Bank, as well as Japan's and Sweden's central banks joined forces in a plan to ease the worldwide liquidity squeeze.
This collusion was a direct reaction to the fact that more conventional instruments have failed. Despite soaring spreads between the federal funds rate and the LIBOR (charged in interbank lending), banks barely touched money provided via the Fed's discount window. Repeated and steep cuts in interest rates and the establishment of reciprocal currency-swap lines fared no better.
The Fed then proceeded to establish a "Term Auction Facility (TAF)", doling out one-month loans to eligible banks. The Bank of England multiplied fivefold its regular term auctions for three months maturities. On December 18, the ECB lent 350 million euros to 390 banks at below market rates.
In March 2008, the Fed lent 29 billion USD to JP Morgan Chase to purchase the ailing broker-dealer Bear Stearns and hundreds of billions of dollars to investment banks through its discount window, hitherto reserved for commercial banks. The Fed agreed to accept as collateral securities tied to "prime" mortgages (by then in as much trouble as their subprime brethren).
The Fed doled the funds out through anonymous auctions, allowing borrowers to avoid the stigma attached to accepting money from a lender of last resort. Interest rates for most lines of credit, though, were set by the markets in (sometimes anonymous) auctions, rather than directly by the central banks, thus removing the central banks' ability to penalize financial institutions whose lax credit policies were, to use a mild understatement, negligent.
Moreover, central banks broadened their range of acceptable collateral to include prime mortgages and commercial paper. This shift completed their transformation from lenders of last resort. Central banks now became the equivalents of financial marketplaces, and akin to many retail banks. Fighting inflation — their erstwhile raison d'etre — has been relegated to the back burner in the face of looming risks of recession and protectionism. In September 2008, the Fed even borrowed money from the Treasury when its own resources were depleted.
As The Economist neatly summed it up (in an article titled "A dirty job, but Someone has to do it", dated December 13, 2007):
"(C)entral banks will now be more intricately involved in the unwinding of the credit mess. Since more banks have access to the liquidity auction, the central banks are implicitly subsidising weaker banks relative to stronger ones. By broadening the range of acceptable collateral, the central banks are taking more risks onto their balance sheets."
Regulatory upheaval is sure to follow. Investment banks are likely to be subjected to the same strictures, reserve requirements, and prohibitions that have applied to commercial banks since 1934. Supervisory agencies and functions will be consolidated and streamlined.
Ultimately, the state is the mother of all insurers, the master policy, the supreme underwriter. When markets fail, insurance firm recoil, and financial instruments disappoint — the government is called in to pick up the pieces, restore trust and order and, hopefully, retreat more gracefully than it was forced to enter.
The state would, therefore, do well to regulate all financial instruments: deposits, derivatives, contracts, loans, mortgages, and all other deeds that are exchanged or traded, whether publicly (in an exchange) or privately. Trading in a new financial instrument should be allowed only after it was submitted for review to the appropriate regulatory authority; a specific risk model was constructed; and reserve requirements were established and applied to all the players in the financial services industry, whether they are banks or other types of intermediaries.
