If you heard a rumor that your bank was insolvent (in other words, it had more liabilities than assets), what would you do? A typical reaction is to panic. What if

If you heard a rumor that your bank was insolvent (in other words, it had more liabilities than assets), what would you do?

A typical reaction is to panic. What if you can’t get your money out? Your next step would likely be to try and get all of your cash in hand.

The rumor could even be false, but if enough people responded as if it were true, it would still spell trouble. Even solvent banks can have illiquid assets. If the bank can’t pay out to its depositors, the panic can spread.

This is where the Federal Reserve System comes into play. The Federal Deposit Insurance Corporation (FDIC) insures deposit accounts. And, if the insurance isn’t enough or the financial institution isn’t covered, the Fed can act as the “lender of last resort” – it can loan enough money to a bank to cover customers who want their cash.

Why does this happen? Well, panics can be a threat to the entire banking system. If one financial institution falls, even if it is insolvent, it can have a domino effect.

If you think through very recent U.S. history, you’ll quickly come up with some examples of the Fed intervening. During the 2008 financial crisis, the Fed, along with U.S. Treasury and FDIC, stepped in to “bail out” insolvent U.S. financial institutions to minimize systemic risk.

But what happens when you know that the government will clean up the mess if you make risky investments? This is certainly a big problem facing the Fed. We’ll discuss the consequences in detail in this video.

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In our earlier videos, we discussed how the Fed uses its control of the money supply to increase or decrease aggregate demand. The Fed, however, has another tool at its command. In a panic, when depositors are running to their bank to withdraw their money, when lenders are refusing to lend, when fire sales are burning down the house, when no one knows where to turn, they turn to the the Fed, the lender of last resort. Panics can be especially dangerous because in the right circumstances they can be set in motion by the tiniest of tremors, and yet they can quickly grow and spread so that they become self-fulfilling.


A panic, for example -- it might start with a simple rumor that a financial institution like a bank is insolvent. An insolvent institution is one with more liabilities than assets. If depositors and lenders fear that their bank is insolvent, they'll quickly rush to withdraw their money, knowing that the last people to withdraw -- they'll be the ones holding the bag. The rumor could even be false. Perhaps the bank has lots of assets, but its assets are illiquid. An illiquid asset is one that's worth a lot in the future, but it can only be sold today at a much lower price -- perhaps because the asset is difficult to value, and it takes time to find the right buyer.


Now think about banks. The main assets that banks hold are loans -- loans that are difficult to value, and that won't pay off until the future. So, banks hold lots of illiquid assets. And if the bank is forced to liquidate early to pay its depositors or lenders, that can create a lot of waste. Banks establish long-term relationships with their customers. Consider a software project, for example. The developer has explained the project to the bank and they get funding. They finish half of the code and they need another loan. It makes sense to go back to the same bank. No one else will understand the project as well. If that bank can't fund the project, the whole thing will probably die! Not only will it be hard to explain the idea to other investors -- those investors may fear an adverse selection problem.

 

Why isn't the bank that knows the project the best making the loan? It's suspicious. A bank run can break the continuity, which is necessary to fund high-value, long-term projects. The depositors, however -- they can't really tell whether the bank is really insolvent or just illiquid. And any hint that the bank isn't ready to pay everyone on demand -- that could make the panic spread. This is where deposit insurance and the Federal Reserve come in. Deposit insurance tells depositors, "Don't worry! Even if the bank is insolvent, you'll still be paid." And because of that guarantee, there's no run. And the bank isn't forced to stop funding the software project until it's finished.


When deposit insurance isn't enough, or when the financial institution isn't covered by deposit insurance, then the Fed can step in as the lender of last resort and provide the bank enough cash to pay off any depositor that wants to be paid off -- again, without requiring the bank to liquidate its assets too early. Traditionally, the Fed lent to solvent but illiquid banks -- to get them through a temporary squeeze -- and it wound down insolvent banks. But in a panic, the Fed may also have to lend to insolvent banks. It may have to bail them out.


The problem in a panic is the problem of systemic risk. In a panic, if one financial institution goes down, it's likely to take others with it, like dominoes. The bankruptcy of one insolvent financial intermediary could take illiquid but solvent institutions down with it. So, the Fed sometimes has to bail out some insolvent banks in order to protect the entire system. At the height of the 2008-2009 financial crisis, for example, the Federal Reserve, the Federal Deposit Insurance Corporation, and the U.S. Treasury stepped in to support the financial system on an unprecedented scale. Deposit insurance, which traditionally had been limited to $100,000 for each bank account -- in effect, it was extended to all accounts, increasing the amount insured by some $8 trillion.


In addition, the U.S. Treasury guaranteed trillions of dollars in money market funds, and the Fed also became the lender of last resort to the commercial paper market. The Fed also went from lender of last resort to owner of last resort when it assumed a majority ownership stake in the insurance company AIG. Why? Because the bankruptcy of AIG would have threatened many other financial intermediaries, and the Fed wanted to create a line break to stop the dominoes from toppling over.


Finally, the U.S. Government stepped in as a lender of last resort and partial owner of General Motors when GM couldn't get funding from banks. But here is the problem. What would you do if you were told that you could invest in anything, and the government would step in and bail you out if you failed? It's pretty clear -- you'd take on more risk, since you would get the benefit of the upside, and the government would be left with the downside. This is the fundamental problem that the Fed faces. When individuals or institutions are insured, they tend to take on too much risk -- the problem of moral hazard.


Big financial institutions -- too big to fail? They have too little incentive to make responsible financial investments. This, in part, is also why the Fed has the role of regulating banks. To minimize this reckless behavior, the Fed imposes conditions on what assets the bank can and must hold. Regulations like this, however -- they have costs of their own, including a more bureaucratic and less flexible banking system. Limiting systemic risk while checking moral hazard -- that's the fundamental problem the Fed faces as a bank regulator.


And today, the shadow banking system does more lending than the traditional banks. And in addition, the financial system has become more complex and intertwined as financial assets are packaged, subdivided, bought and sold more than ever before. As a result, the Fed's lender of last resort and regulatory functions have become much more important and much more complex. The Fed is trying to steer a course between these two problems. If a panic occurs, it may be best to bail out some firms -- even bad actors -- to protect the system. And yet, the promise to bail out firms in a future panic -- that encourages risk-taking, and it increases the probability that a panic will happen in the first place. It's not obvious that the Fed has the tools to steer clear of both problems. This is the great dilemma of modern monetary policy.

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