famously observed that nothing is certain in life except death and taxes. If he were around today he’d be tempted to add one more to the list: bailouts. The recent collapse of Silicon Valley Bank—a midsize institution at best with 17 branches in California and Massachusetts and $175 billion in total deposits—followed an all-too-familiar script of panic and rushed government intervention.
Financial distress never takes long to cross the Atlantic.
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one of Switzerland’s two megabanks, had been beleaguered ever since the financial crisis because of a series of missteps and scandals. The bank reported a loss of $7.9 billion in 2022 and depositors withdrew more than $100 billion in the same year. When share prices plunged and deposit flight accelerated following SVB’s collapse, the
Swiss National Bank
had to step in with a $54 billion lending lifeline. It wasn’t enough. On Sunday Credit Suisse was sold at a knock-down price to its old rival
In the U.S., the bailout came in the form of a blanket guarantee for uninsured depositors with more than $250,000 in the bank, effectively eliminating the limit on deposit insurance. But the government response didn’t end there. The Federal Reserve also devised a new way to ease the pain of banks that forgot to hedge their exposure to rising interest rates. Its new Bank Term Funding Program, or BTFP, gives banks access to Fed liquidity to meet potential deposit outflows by borrowing against long-term securities that the banks own. In the financial world, such lending against securities is standard practice. It is the fuel behind the $15 trillion repo market, one of the largest and most liquid financial markets in the world.
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Yet such markets function based on so-called haircuts. Those with a security worth $100, for example, can borrow under its market value—say, at $90—which leaves a safety margin for the lender. The Fed’s new program is best thought of as a hair-extension operation. Under the BTFP, banks can borrow $100 from the central bank for securities with that face value but far less actual value. It’s a boon for institutions with security portfolios that are deep under water.
JPMorgan estimates that under the program the Fed might lend up to $2 trillion to banks and expand its own balance sheet by the same amount. The same week it launched BTFP, the central bank appeared to abandon its attempt to shrink its balance sheet after various rounds of quantitative easing since the financial crisis. In response, traders have sharply pared down their bets for further interest-rate increases and are now even pricing in interest-rate cuts later this year. Never mind that inflationary pressures are still running high.
As we show in a new paper on the history of the central-bank “safety net,” the SVB crisis elicited a classic response of Fed balance-sheet expansion to offset private losses. The past half century has witnessed a dramatic rise in the frequency of financial crises and market meltdowns. We now live in an age of latent financial fragility. Policy interventions by central banks have grown bolder and now play a crucial role in stabilizing an inherently fragile credit system. The invisible hand of the market has, time and again, needed an outsize helping hand.
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Historically, the main role of central banks was to help the government—especially during war. Indeed, for most modern history, large expansions in their balance sheets were driven primarily by geopolitical conflicts. In the 19th century, however, central banks led by the Bank of England created a second reason for balance-sheet expansion: the role of lender of last resort in financial emergencies. When nobody else was willing to lend, the central bank stepped in to calm the markets, stop bank runs and halt fire sales of assets.
Yet it wasn’t until the second half of the 20th century that large-scale liquidity provisions in crises became a systematic response. Our work, consisting of a sample of 17 advanced economies, shows that the central bank has expanded its balance sheet to calm financial markets in more than half of the crises since World War II. And central-bank balance sheets have risen to unprecedented heights relative to gross domestic product since the 2008-09 financial crisis and the 2020-21 pandemic.
Such lender-of-last-resort operations have always encountered criticism. Hawks in charge of central banks have typically been skeptical of providing liquidity support to badly managed banks. In their view, emergency lending encourages more risk-taking—and enmeshes the central bank in the tricky business of picking winners and losers among imperiled banks. Doves, by contrast, emphasize the dangers of inaction, pointing to the negative economic consequences of unchecked bank runs. Why should Main Street be made to pay for the excesses of Wall Street, as happened so disastrously after 1929?
History has something to teach us about this long-running argument between central-bank hawks and doves. The verdict—based on four centuries of data—is clear. In the short run, the doves have the better case. Output falls less and recovers more quickly when doves are in charge and a central bank intervenes more readily. Monetary aggregates remain stable and deflation—a typical byproduct of full-blown financial crises—is mostly avoided.
But over the longer run the hawks have a point. The historical record also shows that providing a financial safety net invites riskier behavior in the period after a financial crisis. We show that the risk of another boom-bust episode in the future rises significantly after central banks have come to the rescue with their expanding balance sheets. Bankers conclude that the central bank can always be counted on to bail them out. In other words, bailouts and loose monetary policy prepare the ground for the next crisis, but this time with even more leverage.
Where does this leave us? We have an emergency escape hatch in the central bank’s balance sheet. Yet we still haven’t figured out how to prevent the moral-hazard problem from getting bigger each time, forcing the central bank to run ever faster only to stand still. That means it isn’t only death, taxes and bailouts that are inevitable—the next financial crisis is, too.
Mr. Ferguson is a senior fellow at the Hoover Institution at Stanford University, a Bloomberg Opinion columnist, and founder of Greenmantle LLC, a consulting firm. Mr. Schularick is a professor of economics at Sciences Po Paris and incoming president of the Kiel Institute for the World Economy.
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