I have a confession to make. During the financial crisis I secretly bailed out the Bank of Montreal. I was part of a vast conspiracy of millions of other Canadians doing the same thing. It's worse. My personal bailout program for the Bank of Montreal started long before the financial crisis. It started when I first arrived in Canada. It's even worser. The Bank of Montreal still has not repaid me what it owes, and my bailout continues to this day. Without this bailout program, the Bank of Montreal could never have continued in business; it would have gone bust centuries ago. This secret bailout program is far bigger than the total market value of Bank of Montreal shares, so the Bank of Montreal is deeply underwater! It would have been much cheaper for me and my fellow conspirators to have bought the Bank of Montreal outright. And we could have earned a far higher return on our investment if we had done that. The Bank of Montreal eagerly borrowed every single dollar we were prepared to lend it in our bailout program, and made a profit by lending those dollars to other borrowers. We should have just lent our dollars directly to those ultimate borrowers, and cut out the middleman.
Or, to say the same thing more simply: I have a chequing account at the Bank of Montreal, and the Bank of Montreal is a bank.
There are real questions that can be asked about the relationship between government and banks, and between central banks and banks. Should central banks act as lender of last resort to commercial banks? If so, in what circumstances and on what terms? How should monetary and fiscal policy be conducted during a recession and/or financial crisis, and how much and by what methods should central banks try to influence the behaviour of commercial banks in order to attain their monetary policy objectives?
I do not know the answers to those questions, but I think they are important. For what it's worth, my hunch is that the channel between central banks and commercial banks currently plays a far larger role in the monetary policy transmission mechanism than it should. And I am very uneasy about the lack of transparency that seems almost inherent in the role of lender of last resort; it's in stark contrast to the transparency of inflation targeting.
David Macdonald has collected the facts of Bank of Canada lending to the commercial banks during the financial crisis. No worries. But his interpretation of those facts is simply to restate those facts in the same way that I restate my facts in my opening paragraph above.
For example, David says (pages 8 and 9):
"In fact, several banks drew government support whose value exceeded the bank’s actual value. Canadian banks were in hot water during the crisis and the Canadian government has remained resolutely secretive about the details."
And on page 28:
"Total support for CIBC was worth almost one and a half times the value of all the company’s shares in March 2009. In fact, almost every day from mid-January 2009 and the end of April, CIBC was completely “underwater,” receiving support worth more than the value of the company."
All banks always borrow more than the value of the bank. (OK, I expect that's not strictly true, and if I searched I could find a counterexample, where a newly-formed bank had raised capital but hadn't yet got its act together to attract some deposits and make some loans.) That doesn't mean the bank is in "hot water", or "underwater". It means it's a bank. Hell, most homeowners with a mortgage worth more than 50% of the value of the property are "underwater" or in "hot water" and being "bailed out" by the mortgage under that definition. Banks typically borrow more than 90% of what they lend. They always live "underwater" and in very "hot water" indeed. That's where banks live.
Banks borrow and lend. Banks' balance sheets are much bigger than the market value of their shares. That's what banks do. Banks are banks.
(Oh, and the one really interesting and important thing about banks, which is what sets them apart from you and me and other financial intermediaries, is that some of banks' liabilities are used as media of exchange. That is the really important fact about banks.)
What we really need is a counterfactual conditional. What would banks have done instead if the Bank of Canada had not provided those loans? Would they have gone bust? Or would they have just had smaller balance sheets? And that analysis is exactly what I didn't find in reading David's Report.
If I hadn't got the mortgage, what would I have done? Maybe I would have gone bust, or maybe I just wouldn't have bought the house? You can't answer that question just by noting that the mortgage was more than my equity in the house.
[Update: let me make the central point even more strongly. When a recession appears more likely, the central bank may offer loans on easier terms. That's what central banks are supposed to do. And commercial banks may accept those loans. That's what banks are supposed to do. We wanted the banks to accept that "bailout" money, whether they needed it or not. The time to get worried is not when banks act like banks and accept that "bailout". The time to get worried is when banks stop acting like banks and don't accept that "bailout". (Or, like many US banks, they just park the "bailout" money back at the same Fed which lent it out in the first place). It's when banks stop acting like banks that we should start to wonder what use they are in the big scheme of things. We wanted the Canadian banks to borrow the "bailout" money. We wanted them to act like banks. The very last thing we should be doing is criticising them for doing this. The very worst result of this Report would be if it made banks more reluctant to borrow and lend in any future recession. That's the last thing we need.)
I own some BNS shares. The Carleton University pension plan almost certainly holds Canadian banks' shares. I have a chequing account at BMO, as mentioned above. I'm probably biased.
Worthwhile Canadian Initiative 
Much agreed, good post. However, I don’t like this:
“I do not know the answers to those questions, but I think they are important. For what it’s worth, my hunch is that the channel between central banks and commercial banks currently plays a far larger role in the monetary policy transmission mechanism than it should.”
Why do you need a hunch when MMT has been on your blog for the past 2-3 years explaining these operations back and forth? Can’t you give credit where credit is due (no pun intended)? and how else could the channel operate if the central is changing the level of bank reserves (oops I do forget you’re referring to Canada with no RR). Anyway what would bother you about this relationship anyhow?
Excellent post.
DDJ: Wow! Thanks! That must be my first post you’ve said you liked!
Good questions. I can’t articulate my answers very well. Short version: because a bank, almost by definition, is an accident waiting to happen. And because I think monetary policy is very important. So I worry that such accident-prone organisations are related to such an important policy. And we can imagine a radically different form of monetary policy that is less reliant on the relationship between banks and central banks via reserves.
Nick – I was trying to think of some witty remark about your closet socialist or crony capitalist leanings, but realized nothing could match the awesomeness of this post so gave up.
Nick, good points, I agree. The CCPA report is a bit shrill. That being said, I do agree that the lack of transparency in LOLR services is a problem – it breeds resentment which in turn spawns reports like the CCPA’s. That’s why I lean towards market-provided LOLR products such as traded liquidity insurance/liquidity options.
“what sets them apart from you and me and other financial intermediaries, is that some of banks’ liabilities are used as media of exchange.”
What about gift certificates, Disney dollars, WalMart dollars, and iphone dollars? What about the time I paid my mechanic with my personal IOU for $20, only to have the mechanic’s employee pay me for some tutoring with the same IOU?
We’re all bankers now!
Great Post! This report was a farce, news coverage was worse!
Thanks Nick — this definitely needed saying. Can’t repeat this enough.
On your comment above “Short version: because a bank, almost by definition, is an accident waiting to happen.”
I presume what you mean by this is that a good chunk of a typical bank’s liabilities are made demandable (these days, convertible into government cash, in the old days, convertible into specie). In fact, any agency that issues short term debt to finance longer term (read: illiquid) assets is potentially an accident waiting to happen. The question for theorists is: what role does short-term debt of this nature play in the resource allocation mechanism? I suspect that it is a second-best solution to an agency problem. If it is, then government interventions can easily make matters worse, than better. (And by worse, I include the outcome of perfect financial stability–as exists in the state of financial autarky).
What would banks have done instead if the Bank of Canada had not provided those loans?
Well, you can ask yourself why did they get them in the first place?
If you can’t free up capital, you can’t lend (i.e. create money) because you need an amount say 6% or whatnot in reserves.
So if the value of your liabilities shrink, you need more capital to cover your new loans – you raise capital. Can’t sell stock, interest rates in the private market were too high, if available at all – here comes the lender of last resort.
and yes, without that lender, you would go bust – simply because you need to raise a capital amount to maintain solvability in an environment that is dry, dry, dry of liquidity for a short period.
Banks don’t “borrow what they lend”….they need capital to create money. That’s it. its called banking. And what they do is discount bills. Discount bad bills, go bust.
Timely since in the Toronto Star they are running a piece from the Centre for Policy Alternatives about how the Harper government secretly bailed out all the Canadian banks in the latest financial crises.
Haven’t read the report myself, but frothing commentary on the Star site point to another example of Harper’s dictatorially and secretively saving the banks on the backs of the Canadian tax payer.
Perhaps someone can comment, what does “bail-out” mean?, is the role of the Central Bank not to “bail-out” banks? How can taxes collected by the government be used to bail-out banks, what is the mechanism?
I have to say that I don’t understand banking, the financial interactions and Toronto Star stories about them. It just confuses me. Are we or aren’t we supposed to bail out banks if by not bailing them out we threaten the normal working of the real economy?
Nick, FWIW, people like myself in occasional blog comments, and people like Steve Horwitz in occasional guest lectures, provide exactly the kind of counter-factual you’re looking for; but every time we do, the response we get is that you liken a free market money system to a barter system. There’s a big disconnect here. You need not agree with the counter-factual, of course, but if you want to answer the kinds of questions you list above, then that requires stepping back and second-guessing some fundamental assumptions about money and credit.
I think Mises’ analysis of money and credit in Human Action and elsewhere (my personal favorite is “Causes of the Economic Crisis”) provide a profound and deeply persuasive synopsis of the “counter-factual.”
I think a lot of people like me are waiting for mainstream economists to address Mises’ arguments head-on. And what I mean by that is, it would be nice if many mainstream economists actually and seriously read Mises’ essays and commented directly on them, as opposed to simply responding to isolated Hayek quotes out of context or the heavily-summarized views of the LVMI crowd.
In my opinion, there is a big, important thing to be addressed there, and it can be kind of disappointing to see such sparse treatment of it by the mainstream economists.
Agree. But
On this blog we more or less understand what a bank is and what it does and why. We have some understanding of what oa CB is, what it does and why. We may have vaque inklings of what money is etc. We may even have some vague concepts of what monetary policy is etc.
But in the public mind, banks “received free money”. Noboody except banks receive “free money”.
Nobody except banks receives “free money” and them serves you morality lessons.
A banker leaves the BoC in his limo after getting his bailout. He sees a panhandler and order his chauffeur to stop. He lowers the window and shout:”Get yourself a job, you lazy bum! ”
Only bank receives “free money” and then tell you to get a job.
Or at least this is how the public sees it.
What we really need is a counterfactual conditional. What would banks have done instead if the Bank of Canada had not provided those loans? Would they have gone bust? Or would they have just had smaller balance sheets? And that analysis is exactly what I didn’t find in reading David’s Report.
wrong question though. we live in a probabilistic universe. its not a certainty either might have happened, its a question of what the probabilities were (and whether there are multiple equilibria, potentially some with critical points whereby the outcome becomes self-reinforcing as we move closer).
Liquidity crises (which is ultimately what topples a bank) appear to be such cases (which is why rumors can destabilize a bank).
i am not a big fan of armchair quarterbacking for that reason (whats the equivalent hockey metaphor?).
I was in an accident once, a car was coming down the road to me head on. The car hit one ahead of me head-on, and the next car in line swerved and sideswiped a tree (leaving a clear path between me and the still-moving car).
Insurance company said to the owner of the car who hit the tree: its your fault (!). But he was swerving to avoid a worse collision!
the moral of the story is: a) one might have to take responsibility for a lesser evil to avoid a much bigger one; b) sometimes the best you can do is ensure sufficient preventative measuers are in place. In the accident case, seatbelts and airbags. in the bank case: liquidity and capital.
Great post, except that you forgot to add that you “have remained resolutely secretive about the details.” OMG!
Nick – superb post
David (author of the CCPA “report”) is one with Moliere’s Monsieur Jourdain’s “discovery that he has “been speaking prose all my life”.
I did read the CCPA report and sprinkled throughout the report, are quotes from Gov Carney and Finance Minister Flaherty annoucements of the “secret” liquidity support. Not clear how it is secret – when he is quoting the Gov and Finance Minister annoucements as evidence of the support. Support empirically verified yes – secret – no.
e.g. “It was a good thing we didn’t press pause when we provided over $30 billion
of liquidity to the Canadian banking system. It was a good thing the government
of Canada didn’t press pause when it provided…very timely and effective
term liquidity to the Canadian banking system.” Mark Carney, pg. 10, CCPA Report
David failed to note that if the aggregate support had been broken down by bank, it could have caused problems for some of the perceived weaker banks ie those that received more support than other banks. Indeed, Carney has spoken about the importance of confidence in the banks on various occasions (as did Geithner frequently re TARP).
David also used the word “bailout” at least 15 times in the report – even while repeatedly discussing the banks’ record profits in Overall Bank Utilization pg 20-30.
David also compared the $114 B in liquidity support provided to the Cdn banks to the market cap of the banks – instead of expressing it as a percentage of total bank assets in Canada ($3.4 trillion) – which is an approariate way to normalize and comp;are the data – and which would have revealed that GoC and BoC support approximated 2.5% of total Cdn bank assets.
Moroever, he failed to compare it to level of support as a percentage of GDP, provided by BoE, BoJ, ECB.
Finally, he characterized the banks’ SALE of CMHC insured mortgages to the GoC – as a bailout – when it was a sale of an asset from one entity to another entity.
Or as Freud allegedly said, sometimes a cigar is simply a cigar.
Hi Ian,
I don’t think much of the CCPA report for many reasons, but I do think they have a point to make about the transparency of the allocation of the intervention. In particular, you say:
“it could have caused problems for some of the perceived weaker banks ie those that received more support than other banks. ”
I say that is exactly the kind of information that market participants ought to have–if not at the time of crisis, then at least now; ex post. If it causes ‘problems’ for weak banks to be exposed as weak banks, I think that is called ‘the market doing its job’.
Interesting that you mention the Bank of Montreal, Nick. I’ve banked there since I was six. It will celebrate its 200th Anniversary in 2017. Expect the requisite show. But it has survived through thick and thin in those two centuries and its relevant to put in perspective just how much trouble the bank was in in 2008.
My sense is that it was uncomfortable but not dangerous, no intervention would have meant curtailed lending but not endangered the life of the bank.
Kevin – yes to transparency at the aggregated level. I was in the Green Room at CTV News Channel this morning speaking with David (he went first and then I followed). I pointed out that the GoC DID disclose the aggregated level of liquidity support – but did NOT provide disaggregated data. David agreed completely with this statement.
Thus, the issue is not about secrecy vs transparency of full reporting for budgetary or accountability reasons.
Rather, the debate concerns whether the public should know about the particular levels of support for specific banks e.g. TD vs CIBC.
This morning David told me that he spoke with BoC re filing an access request and the BoC advised him they would deny it. Presumably due to commercial confidentiality or perhaps my argument, to ensure stability of financial instituions and not create a run on a bank.
As every economist and banker knows, “confidence” in a firm or a bank is intangible and elusive. But when it collapses, well … – remember Nortel.
BTW, today at Economic Club Carney spoke and stated unequivocally that liquidity support is NOT a bailout.
I made the same argument this morning:
David: link here NR
My response: link here NR
link to Interfluidity post here NR
It appears that somebody didn’t do the Bagehot reading assignment …
Nick: Great post. Wish I could write intros like yours.
But reading through the post and the comments, I’m at a loss to know whether govt support of the Canadian banking industry (broadly defined to include the BoC’s actions) cost anything. Or when we might find out, if it did. Like you, I don’t agree with MacDonald’s call to “release the full details of how much support each Canadian bank received, when they received it, and what they put up as collateral.” I’d be more interested in knowing whether
– all support has been repaid (with interest at least equal to the government’s opportunity cost of funds)
– what assets (if any) the BoC and Govt. acquired from troubled institutions, at what price, and their liquidation values.
I suspect the answers to several of these questions might already be in the public domain. Perhaps you or other readers can help me find the answers.
Thanks Trevor and Frances!
JP: “That being said, I do agree that the lack of transparency in LOLR services is a problem – it breeds resentment which in turn spawns reports like the CCPA’s.”
Agreed. But I’m not sure that this case was a LOLR action for the banks themselves (as opposed to the rest of the economy).
“That’s why I lean towards market-provided LOLR products such as traded liquidity insurance/liquidity options.”
I’m not sure whether or not that could work, in a system-wide liquidity crisis, if it wasn’t backed by the ultimate creator of money.
Mike: “What about the time I paid my mechanic with my personal IOU for $20, only to have the mechanic’s employee pay me for some tutoring with the same IOU?”
The exception that proves the rule! The fact that you remembered that particular case shows it’s rare. Most Wicksellian triangles have many more than three sides, and the corners don’t all know each other.
Jeremy: thanks! I stumbled across the news this morning, thought “WTF?”, had a look at the Report, and wrote this.
David: Thanks! “I presume what you mean by this is…”
Yep. That’s pretty much what I meant. Banks borrow short, safe, and simple, and lend long, risky, and complex. Presumably they do change the allocation of resources, otherwise they wouldn’t need to exist. Whether or not the government (central bank) is needed to help them do this, by acting as LOLR, I still see as an open question. Banks as we know them aren’t the only way to do this job. But second-best interventions in an agency problem can sometimes help. Depends on the intervention.
Bob: “What would banks have done instead if the Bank of Canada had not provided those loans?
Well, you can ask yourself why did they get them in the first place?”
Because the Bank of Canada wanted them to increase lending to other borrowers, and rather than do that itself, the Bank of Canada bought some of the existing assets off the banks?
Antonio: “Perhaps someone can comment, what does “bail-out” mean?”
Good question, when applied to banks. But one not answered, or even addressed, by this Report. I would say there are two conditions: that the bank(s) would have been in trouble without the bailout; and that the bailout was costly to the government. Neither of which I could see being argued for in the Report.
“Are we or aren’t we supposed to bail out banks if by not bailing them out we threaten the normal working of the real economy?”
Most economists would say that we need to bail out banks (in the full sense of “bailout”) under some circumstances, because the costs of not bailing them out could be even worse. But many of us find that answer unsatisfactory, even if we accept it under present arrangements. It’s an open question.
Ryan: “You need not agree with the counter-factual, of course, but if you want to answer the kinds of questions you list above, then that requires stepping back and second-guessing some fundamental assumptions about money and credit.”
Yep. It’s hard to address those questions without going deep. I can’t remember HA and TMC well enough to say for sure, but I don’t remember a big “Aha!” moment that totally changed my views on everything concerning money and credit.
“In my opinion, there is a big, important thing to be addressed there, and it can be kind of disappointing to see such sparse treatment of it by the mainstream economists.”
Maybe it’s not that we’re not trying. Maybe some of these questions are just hard. Haven’t you seen me desperately banging my head against some of them? Superman leaps tall buildings in a single bound. The rest of us mortals try to leave a good set of scratches reasonably high up the side of the building. Then argue about whose scratch marks are highest, and whether we’ve got the right building.
Jacques Rene: “But in the public mind, banks “received free money”. Noboody except banks receive “free money”.
Nobody except banks receives “free money” and them serves you morality lessons.”
Yep. It’s even worse when you think that banks can create free money, which they both can and can’t. And then charge interest on it! And where does interest come from anyway?? Money and banking is fertile ground for conspiracy theories, of both left and right. Social Credit, for example.
dwb: “wrong question though. we live in a probabilistic universe. its not a certainty either might have happened, its a question of what the probabilities were (and whether there are multiple equilibria, potentially some with critical points whereby the outcome becomes self-reinforcing as we move closer).”
I would say that your question is a better version of my question. If he had first answered my ex post question, we could then have asked your ex ante version. We never got anywhere near step one.
Phil: thanks! Yep. And I’m still keeping mum about how much exactly I bailed out BMO!
Ian: thanks! I wondered if you would have gotten involved in this story. Good additional points and facts.
Kevin and Ian: yep. That’s why I said that lack of transparency seems to be almost inherent in the role of LOLR. Not just secrecy. But if we could formalise the rules, and put Bagehot into a computer program, I wonder if we would even need a LOLR in the first place?
Determinant: “My sense is that it was uncomfortable but not dangerous, no intervention would have meant curtailed lending but not endangered the life of the bank.”
That is my sense too, but i don’t know for sure. Part of the problem is that we need to look at this not just from the perspective of the single banks, or even of the financial system as a whole. We need to look at the whole macroeconomy. If NGDP had fallen far enough, if the BoC had acted differently, not even the safest bank would have been safe (though they did survive the Depression).
Rev Moon. Yep. Worth a re-read.
Patrick. I don’t think we need to go as far as reading Bagehot, in this case. Just remember that a bank is a firm whose primary business is both to borrow and lend. Most firms say “yes” when you offer them more of the business they normally do. It wouldn’t be surprising if you or I turned down an offer of a loan on easier terms. Because we are not banks.
Thanks Simon! The intro was what took all the thought. That’s what makes me an econoslut! The rest was just ECON1000, plus recycling half-remembered lines from other bloggers (probably Brad DeLong or Willen Buiter or someone).
The ex-post accounting question of the government’s profit or loss would be worth knowing. But only as a start. The ex ante counterfactual conditional is the biggie.
So much for secrecy, the CCPA could have saved itself a lot of trouble uncovering the “secret” $114 billion “bail-out” by citing this chapter of the government’s Second Report on the “Canadian Action Plan” (thank you Michael Ignatieff) to the effect that: “Over $115 billion in financing support has been provided, all of it on a commercial basis to protect the taxpayer”
“I’m at a loss to know whether govt support of the Canadian banking industry (broadly defined to include the BoC’s actions) cost anything.”
The government claims that the terms were “commercial”, but who knows. I do have a vague recollection of department of Finance press releasees crowing about how favourable the terms were, but I’m too lazy to look them.
Finance did prepare this report, seemingly for parliament, which suggests that the Insured Mortgage Purchase Program was structured in such a way as to ensure a spread between the government’s cost of finance and the return on the mortages being purchased (at minimal addition risk to the government – there was some counterparty risk on interest rate swaps for variable mortgages).
There’s this press release from Finance to the effect that the IMPP program was producing a “positive return” , though I’d take anything out of Finance with a hefty grain of salt.
[edited to embed links NR]
I do know that a Senior Official with whom I had a corridor chat about it was very satisfied with how it went. “We made money on it” is how he put it.
BTW, I add my voice to the chorus of praise for this post. A gem.
Nick,
“When a recession appears more likely, the central bank may offer loans on easier terms. That’s what central banks are supposed to do.”
Should ordinary people get bank loans on easier terms in those circumstances too? Preferential treatment of banks creates hostility between population and bankers.
Great job Nic,
I remember reading a Bloomberg article about Fed lending at the discount window being larger than TARP and the AIG bailouts combined but that none of the Fed loans had any political oversight or some such nonsense. The article was written as if the author had uncovered some great scandal.
MacDonald and the author of the Bloomberg article don’t seem realize what a central bank is saying when it announces a target for the overnight rate: that the central bank has pledged to lend in unlimited quantities to prevent the rate from rising above its stated target. The central bank is ALWAYS promising to lend massive amounts of money if need be – but it’s only times of financial stress that banks take them up on the offer. In normal times they mostly borrow and lend from each other. But in a crisis banks are unwilling to lend to one another and would prefer to borrow from the discount window.
Progressives 100 years ago understood all of this very well. Indeed, they were the driving force behind the creation of the Fed which they demanded perform precisely this function to avoid a repeat of the Panic of 1907. But today’s progressives seem to not grasp this at all.
What’s really frustrating is that had the government said something along the lines of “we’ll let the market take care of itself” and a bank had failed, the CCPA would have (quite fairly) blasted them for sacrificing the Canadian economy on the alter of neo-liberal free-market ideology (did I get the jargon right?). Intead, the government came up a clever way of providing the banks with liquidity without bailing them out or taking on any significant risk (and making a buck or two in the process) and they get blasted for bailing out the banks.
Anyone remember the old Mad Magazine cartoon about how you can’t win with a bigot…
“But today’s progressives seem to not grasp this at all.”
I’m bemused that the ‘progressive’ position appears to be to just let banks fail; liquidate them in a crisis. That seems more like what the internet-trained Austrian economists advocate.
I wonder what internet blog conspiracy the CCPA will take up next. Uncovering the ‘secret true’ inflation rate? Will they start spelling things internet comment-style too? You’re a looser! That’s rediculous!
Stephen: thanks! And thanks for tweeting it. Just wish I had written this yesterday. Seems like the newspapers have now moved onto other things.
Alex: “Should ordinary people get bank loans on easier terms in those circumstances too?”
Again, the whole point of banks is to both borrow and lend. That’s what banks do. They don’t just borrow. And the whole point of the “bailout”, AFAIK, was to increase the supply of bank lending, so that by offering more and cheaper loans to banks, banks would in turn offer more and cheaper loans to their customers.
Now it’s true, the Bank of Canada could have made loans directly to ordinary people and businesses. And we could discuss the merits of whether or not the central bank should get directly involved in retail banking. But again, that is not normally what central banks do, and it would have been difficult for the Bank of Canada to have hired a lot of loan officers and set up a whole branch banking system very quickly when the recession appeared imminent. Instead, it stuck to its normal business of being banker to banks and the government only. It doesn’t accept deposits from you and me (except when we hold currency).
Though, from what I’ve heard, the government did get Export Development Canada (which was already in the retail business and (presumably) knows what it is doing) to expand its business and make more business loans.
Gregor: thanks!
“The central bank is ALWAYS promising to lend massive amounts of money if need be – but it’s only times of financial stress that banks take them up on the offer. In normal times they mostly borrow and lend from each other.”
and, I would add, from normal people and firms.
This is how I think of it. In normal times, if the Bank of Canada wants to loosen monetary policy to prevent inflation falling below target, it lowers the overnight rate target, and banks in aggregate automatically start to create loans and deposits simultaneously, lending and borrowing from ordinary people and firms, which creates a monetary hot potato, and Aggregate Demand expands, until the Bank of Canada reckons they have done enough and raises the overnight rate back up again to stop inflation rising above target. But yes, in the financial crisis the Bank of Canada thought this wasn’t enough and decided to make loans available on a longer term basis than just overnight. And the banks, as the BoC hoped, took up the offer. (And in hindsight, and perhaps foresight too, the Bank of Canada can be faulted for not having been aggressive enough in doing this, and preventing NGDP falling relative to trend, but now I am going off topic, and will restrain myself).
“Progressives 100 years ago understood all of this very well. Indeed, they were the driving force behind the creation of the Fed which they demanded perform precisely this function to avoid a repeat of the Panic of 1907. But today’s progressives seem to not grasp this at all.”
Bingo! Did Ron Paul manage to infiltrate the CCPA?
Kevin: “internet-trained Austrian economists”
Awesome!
Curiously, the CCPA has less to say about ACTUAL corporate bailout, notably of GM and Chrysler (not that there weren’t reasonable arguments for intervention in those cases – but those were bailouts). I wonder why that is…
In unrelated news, I see that a number of CAW employees(Jim Stanford, Bill Murnighan) write for the CCPA and the CAW is listed as a supporting/participating organization as part of their Trade and Investment Research Project.
Nick,
“Now it’s true, the Bank of Canada could have made loans directly to ordinary people and businesses.”
Nope, there are many other options: subsidies, guarantees, etc.
Should ordinary people get bank loans on easier terms in those circumstances too? Preferential treatment of banks creates hostility between population and bankers.
At the height of the crisis, some bankers in the US balked at the terms and didn’t want to re-open (extravagant) compensation contracts, some resorted to Fifth Amendment arguments. To which I thought: when you come begging before the throne, it behooves you to be humble. (Extravagant) Bonuses have no place when the taxpayer is saving your firm from bankruptcy and you and your fellow employees from unemployment.
Of course all banks borrow more than the value of the bank, but we’re talking about taxpayer money here. If a bank is receiving such money, then there need to be strict terms of borrowing – which there have not been, historically. We live in a democracy, and people deserve to have full disclosure over how public money is being used. Political economy matters much more than some economists think.
Cornelius: “If a bank is receiving such [taxpayer] money, then there need to be strict terms of borrowing – which there have not been, historically.”
If we are talking about repoing things like CMHC-backed mortgages, which are already guaranteed by the Federal Government, as in this particular case, that isn’t really an issue. But yes, if we are talking about genuine LOLR actions, it is an issue. Unfortunately, I find it hard to reconcile the sort of LOLR actions that might sometimes be needed with strict rules of borrowing. Valuing the sort of assets that might serve as colateral might in practice be a judgement call, that needs to be done quickly and sometimes secretly. The LOLR role is a nasty one. Maybe there’s a better way.
Nick: “The LOLR role is a nasty one. Maybe there’s a better way.”
There’s always 100% reserves, with loans backed by 100% capital. As Mankiw once pointed out, there is just no reason to believe that there are any associated efficiency costs. And, of course, lots of other even better solutions as we’ve discussed here many times.
Did you get a chance to consider my really excellent reply to you in the Short vs Long Run Natural Rate of Interest post? 🙂
“I’m bemused that the ‘progressive’ position appears to be to just let banks fail; liquidate them in a crisis. That seems more like what the internet-trained Austrian economists advocate.”
I think the point is more to make people recognize that much of the shareholder value in a bank is contingent upon government support (but don’t call it a bailout!) in tough times, so when bankers try to argue (not that they do much in Canada, they tend to keep a low profile) that they are entitled to large profits and big bonuses because they earned them in a free market and sailed through the recession without needing a bailout, people realize that the truth is a bit more complex and that commercial banks are quasi-public bodies for the reasons that Nick outlines in his post.
For the most part, impending meltdown in the mortgage market notwithstanding, I think we manage this fairly well in Canada – the government tolerates a cozy oligopolistic banking sector and in return the banks pay their taxes, keep things steady and don’t go overboard competing or bonus paying or ‘innovating’ themselves into bankruptcy. Given the tenor of the times (despite the recent meltdown, still best exemplified by the incident where regulators staged a photo-op of themselves taking a chainsaw to a stack of financial regulations) it probably takes a little pushing from the left to keep this system in place, so from an end-justifies-the-means perspective, the CCPA report is probably helpful, regardless of the exaggerated nature of some of the claims made.
much of the shareholder value in a bank is contingent upon government support
No, you’re missing the point. Shareholder equity was not really in danger; those mortgage assets were safe. The scenario that the IMPP was trying to avoid was that the banks would simply stop lending and be forced to start calling in existing loans.
Here’s how I put it on twitter:
Scenario 1: You go to the ATM to withdraw $1000 and are told you have insufficient funds. A friend gives you $1000.
Scenario 2: You go to the ATM to withdraw $1000 and find that although you have plenty of money in your account, there’s a technical malfunction and you can’t get access to it. Your friend gives you $1000 cash in exchange for a cheque for $1100. Your friend deposits the cheque without incident (you aren’t insolvent) and you use the $1000 to keep body and soul together, although you may be grumbling about how your friend was taking advantage of your misfortune. When the ATM is finally repaired, you go back to using it.
Scenario 1 played out in the US; that was a bailout. We had Scenario 2. You can call it a bailout if you want, but as far as I’m concerned, doing so is a willful misrepresentation of what happened.
Stephen, you’re right, shareholder equity was not in danger, but in reality it’s not easy for banks to “stop lending” or “to start calling in existing loans” – pre-committed, irrevocable lines of credit can be drawn at the discretion of the borrower. Banks would be more worried about the inter-bank market, this is where the CBs need to provide funds otherwise it would freeze up. To call it a bail-out is not correct. It sounds like the Canadian banks were not insolvent, but had liquidity problems instead.
Declan: If that is how this is perceived, then in the interest of transparency the Bank of Canada should clearly state:
“Look, we really really want you to accept this loan, whether you need it or not, and increase your own lending in turn. But we must warn you that this loan comes with strings attached. If you accept it then the Canadian Centre for Policy Alternatives will call it a bailout, and say that you are in hot water and deeply underwater, and most journalists will pass on that accusation without comment. Furthermore, we will consider you a quasi-public body from now on, and so the government will want a say in how much profit you earn and what bonuses you pay. So think very carefully before accepting this loan.“
Nick: As we have seen recently there are plenty of people who have a fundamental misunderstanding of how banks work. Plus, grumbling about how banks operate in a constant state of insolvency since they cannot pay bank their debts on demand, so only exist due an implicit government backing. But governments regulate capital requirements and control benchmark interest rates so have a lot to say about bank profitability. Finally, since banks are licensed credit-money issuers perhaps it is right to consider them quasi-public bodies!
Actually, the more I think about it, the more pissed off I get. This wasn’t some blog post, banged out at midnight, where stuff happens. They must have done a lot of work getting all that data. And it was reviewed by some very good economists, who cannot of course be held responsible for the content, but who must have told them that the “analysis” simply wasn’t there to justify the interpretation, and that banks are banks. And they put a lot of work into the presentation, and publicising the Report, and doing interviews.
This was a very carefully planned hatchet job. The thought that should have gone into analysis and interpretation went instead into political spin.
HJC: Banks historically have (sometimes) existed without any LOLR. Whether that is a good or bad thing is another question. It is not obvious to me that the fact that banks’ liabilities are used as media of exchange makes them automatically quasi-public bodies. (Some say that government should get out of the money-business altogether). Yes, governments regulate banks, but the argument “we regulate you, therefore we have a right to have a say in everything you do” seems to be weak.
But if the government offers you a no-strings loan, that it wants you to accept, and you accept it, and then the government afterwards turns around and says: “Aha! You took our money, and that means you belong to us and we can do anything we like!” is a bad argument, both on deontological and consequentialist grounds.
I am suddenly reminded of my late colleague TK Rymes. TK used to argue that Carleton should refuse to accept any government money, because it would inevitably lead to full government control of what we taught and how we taught it and who taught it.
“You want a business loan, or mortgage? Are you in the government’s good books?”
HJC @6:42am. That is (the beginning of) exactly the sort of analysis that should have been done in this Report, but wasn’t. The distinction between liquidity and solvency, and an attempt to assess liquidity of existing assets and liabilities. Were banks calling in good loans and lines of credit at an unusually high rate, or dumping lots of assets at firesale prices, etc.?
K: I had a read through that Mankiw link on 100% reserves. I think that what he misses is the principal-agent problem. One of the explicit assumptions of the Mogliani-Miller theorem, IIRC, is no agency problems. Banks make loans whose quality is costly to verify. So the bank itself becomes the residual claimant so it has the full incentive to monitor those loans properly, and the rest of us who hold deposits at the bank don’t have to go over their loans and check their quality. But of course, this only works up to a certain point, because if enough loans are bad enough then the depositors are on the hook too. The MM theorem says the debt/equity ratio is indeterminate. If we add agency problems we can get an interior solution.
Sorry. I couldn’t think of anything useful to say on your Short vs Long comment. Maybe it will slowly percolate in the back of my mind, and reappear in a later post 😉
Banks are licensed to create credit-money and their liabilities are now a (the most?) common form of payment. Their lending increases the broad money supply. Perhaps not technically quasi-public but the government is only other body that has this power.
I suspect that the the periods without LOLR correspond with a high incidence of bank runs.
As I said before, it’s not easy to call in good loans (or bad!) most are committed to be used at the discretion of the borrower. It is more likely that lines of credit are being drawn at a high rate. During a crisis is precisely when bank assets are most illiquid and unpredictable. This is when Bagehot’s famous dictum is most relevant.
It’s true that regulators haven’t used their powers too much recently but they are flexing their muscles now and they are having a lot of say in how things are and will be done!
Based on conversations with friends & family, I’d say many people don’t understand that illiquidity can be infectious among banks precisely because they are banks; they don’t have giant piles of cash sitting around. They all rely on each other, and if the system takes a bit enough hit it can fall over unless there is a LOLR (and if it falls over unemployment can and does increase very very rapidly).
FWIW, I suspect things like the CCPA report get traction in the media because people tend to try to understand financial ‘news’ by analogy, and in most people’s lives there’s no meaningful difference between insolvent and illiquid, so when they read stuff like the CCPA report they predictably get all hot and bothered. Most of us don’t live in reality where we have a big stack of mortgages and no cash.
Cornelius: Of course all banks borrow more than the value of the bank, but we’re talking about taxpayer money here. If a bank is receiving such money, then there need to be strict terms of borrowing – which there have not been, historically.
Just to be clear, the big chunk of the program didn’t entail banks borrowing public money. The IMPP involved the banks SELLING their government guaranteed assets (insured mortgages) to the government for cash.
And for what it’s worth, the Montreal Gazette’s cites a spokesman for Jim Flaherty to the effect that by 2015, the government will have netted %2.5 billion dollars from the program – hey, 10% of the way to paying for new fighter jets.