Thursday, May 17, 2012

The free banking alternative to the centralized provision of lender of last resort services

Inspired by Perry Mehrling and Fischer Black:
I think I'd take your future ideal financial model even further (slide 9). The C5 in your model provides what you call liquidity puts. I see no reason why these liquidity puts need be provided by a central bank. In the future, financial products called liquidity options - the option to buy or sell some asset (say Apple stock) at a guaranteed point in the bid-ask spread - would be popular financial products traded on organized exchanges. Just as Apple CDS allow investors to split off Apple credit risk and distribute it across the economy, so would Apple liquidity options split away the liquidity risk of transacting in Apple stock in the secondary market and evenly distribute this risk to those willing and capable of holding it.
A private liquidity options market has some advantages over a monopoly last resort system. Liquidity would be competitively priced and no longer supplied in an opaque manner. Central banks would either vacate the market for liquidity services or price their liquidity products off the private liquidity options market. Subsidies to or penalties on institutions anxious for liquidity insurance would be a thing of the past.
If central banks were to cease providing liquidity options, their sole role in the future would be as managers of the clearing and settlement system. The provision of paper money can be easily fulfilled by private banks. I guess central banks would also have to manage the price level.
The above is a free-banking view of the world. The lender-of-last resort role is transferred from central banks to private markets. It is distilled into just another financial product.

5 comments:

  1. JP:

    Great blog (or non-blog)!

    Two observations about a lender of last resort:
    1) Insolvent banks can't be helped by a lender of last resort.
    2) Solvent banks don't need a lender of last resort.

    Conclusion: We don't need no lender of last resort.

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  2. Hi Mike, good to see you.

    I'm not going to disagree here.

    "We" may no need a LOLR, but I don't doubt that there are individuals and institutions who would like to own financial products - I call them liquidity options - that protect them in a scenario in which they are forced to sell their assets in haste to raise cash. Solvent banks from time to time need to sell off assets in panicking markets to meet redemption requests, so do consumers. Both might want to hold a portfolio of liquidity options as protection.

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    Replies
    1. Seems like liquidity options would work, but I can't find any historical examples, so maybe there's something impractical about them (like: Who bails out the bailer-outer?)

      The thing I do see a lot of is 30-60 day suspension clauses on bank-issued money. If done right, that can eliminate the need to sell assets at fire sale prices. That prevents insolvency, and we're back to not needing a lender of last resort.

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  3. Yes, liquidity options lack precedent.

    It's not just banks who have suspension clauses. Mutual funds and hedge funds experiencing redemptions will often impose a six month delay before cash will be returned. This prevents them from having to sell relatively illiquid stocks at large discounts in order to satisfy redemption requests.

    Liquidity options would serve the same purpose as suspension clauses. Rather than suspending redemption, a mutual fund could simply exercise several liquidity options to sell securities at a liquidity protected price, thereby quickly raising the cash necessary to meet redemption.

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  4. ...rethinking this.

    A formal liquidity options market lacks precedent. But anytime a store sells you something with the option to sell it back to the store for full retail price, they've given you a liquidity option.

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