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March 17, 2008
Some thoughts on the day after: Bring back Glass-Stegall?
I couldn't resist watching a little CNBC tonight. Kudlow was talking about how the Fed should have opened the discount window up to investment banks sooner. After all, Glass-Stegall was repealed in 1999. Since then, the role of investment banks in the financial system has expanded, and they have become intertwined with commercial banks (i.e. depository institutions). But all this time, houses like Bear Stearns have been working without a net. They've been unable to tap the discount window.
So the Kudlows of the world would like to have seen the Fed open the discount window to investment banks sooner. That way, maybe they could have survived this crisis. Hmm... maybe... maybe not. It might have prolonged the agony and the result would have looked more like Continental Illinois which although it came to a head in a day, took weeks for the FDIC to finally take the assets. All the while, they had access to the window and to a number of other banks (who were presumably willing to lend to CI because it had access to the window) to help them liquidate. In terms of restoring confidence to the system, it was probably better this way. Here's the deal. Take it or leave it. They had no choice but to take it.
If it turns out that there is another Bear Stearns out there waiting to happen, you can bet that it will unfold differently now that investment banks have access to the discount window. Should this change be made permanent? Should investment banks have access to the discount window at all times?
That's a tougher question. First, look at the way the Fed's announcement actually reads. They aren't lending directly to the investment banks... they are going through the primary dealers. (It happens that Bear Stearns was a primary dealer so in that case it would have been direct, but it would not necessarily be so in every case.)
First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets.... Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities.
The fact of the matter is that now that this is out there it will be tough to put the genie back in the bottle. It's definitely a good idea in times of crisis. It is probably also a good thing to have on the books so that you don't get caught off-guard in the future. I would only amend it so that the credit is available at a penalty rate. Read Bagehot for the reason why.
Is it necessary to open the window directly to investment banks who are not primary dealers? No, and probably not a good idea either--except as already provided under statute in exigent circumstances. Let's see how this works, and if it works, just keep it on the books as it was announced yesterday.
Now let's look at the other end of the spectrum. For each person like Kudlow who would want to open the discount window to investment banks directly, there is probably a person who would want to reinstate Glass-Stegall and put the wall of separation between investment banks and commercial banks back up again.
But I don't see that as being the problem.
Glass-Stegall was meant to keep the commercial banks from engaging in speculative investment activities that would put customer deposits at risk. That's not what happened here, nor is it likely to be a big issue. The problem is that investment banks dependent on short term repos for daily financing are now as critical (if not more critical) for the stability of the system than the commercial banks of old. They also seem to be as prone (if not more prone) to the kinds of lapses in judgment that led to what we saw this weekend. But walling them off, even if it were realistic to do so now, would not make them go away, get smaller, or suddenly get better judgment.
So how do you get them to behave? Act as their lender of last resort? Lots of moral hazard, not enough moral authority. But perhaps by allowing their peers (here I am referring to the primary dealers) to be their lender (or buyer) of last resort you enforce a kind of market discipline that the Fed alone would have trouble enforcing. Was Bear Stearns a sacrificial lamb on this altar, as many are suggesting? Perhaps. And although I cannot do anything other than speculate as to whether that was the intent, it certainly was the way it worked out. It's too late to do anything about that now, and perhaps it was too late even last week. We'll never know.
But now that a mechanism is in place, I would simply prefer that next time it be done by lending to them at a penalty rate instead of buying at a discount.
Posted by William Polley at March 17, 2008 7:29 PM
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